Another valuation is the ratio of the pre-tax return to the operating results, Rop:
R/Rop (8.2)
This ratio indicates the impact of risk provisioning, special write-downs and other income/expenditure on overall return.
The use of operating income, Iop, provides another metric denoting operational efficiency (it corresponds to: 1⫺cost-to-income ratio):
Rop/Iop (8.3)
Still another metric, known as revenue efficiency, indicates the contribution made by the revenue side to ROE:
Iop/E (8.4)
The ratio of operating income to risk-weighted assets (RWA) is a measure of asset productivity. It focuses on income in relation to risk:
Iop/RWA (8.5)
An entity’s risk profile is measured by the ratio of risk-weighted assets to total assets. This is an increasingly popular metric, with proxy for assets A, the stock market capitalization of the firm:
RWA/A (8.6)
Leverage of the balance sheet is determined by the ratio of capitalization-based assets to balance sheet equity:
A/E (8.7)
In essence:
(8.8)
Apart from the impact on positions themselves, a growing risk appetite has after-effects on financial stability. Excessive risk taking pushes asset prices beyond their intrinsic value and, if it persists, could sow the seeds of financial market stress because of:
● Misallocation of capital in the economy, and
● Development of disorderly conditions in financial markets.
Risk appetite and risk aversion are different but complementary concepts that can be used to measure the degree of leveraging in financial markets. Risk aver- sion refers to the reluctance of an investor to accept a position with uncertain risk and return, rather than another position with a more certain exposure but lower expected return.
Several years ago, analysts and rocket scientists tried to create risk appetite models, but it has been gradually found that these are ineffective in forecasting the truly big sell-offs when risk appetite turns to risk aversion. The market down- turn and sell-off of mid-May 2006 had little to do with the macroeconomic situ- ation (which enters into these models), even if a sustained bear market can lead to poor economic conditions.
In the opinion of several analysts, a prolonged period of low volatility is a sign of unhealthy risk appetite. Several experts suggest that the mid-May 2006 event had plenty to do with an excessive appetite for risk, which provoked a wave of risk aversion. Many experts now think that:
● The degree of risk appetite prevailing in financial markets can be observed only on an aggregate basis, and
● It contrasts with the degree of risk aversion, a concept that explains the behaviour of investors in periods of uncertainty.
Several studies in this domain involve the examination of a set of financial mar- ket variables that have historically shown a high level of sensitivity to swings in risk tolerance. Others chose interviews of financial market participants about their opinion on the pricing of different risky assets. Sometimes, however, the polling of experts’ opinions features accuracy risk.
For instance, when on 11 January 2007 the price of a barrel of crude hit $52, several analysts and traders suggested that the $75 price it reached in mid-2006 was overdone by at least $15–20, due to geopolitical reasons and speculation. In fact, in mid-January 2007 some traders went short on oil and suffered because of it due to the dual effect of Iranian belligerence and a delayed cold winter. On the
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other hand, interviews with experts during the market downturn in May 2006 gave a useful warning that volatility was rising (shortly thereafter, volatility again had a low profile).
A good way of assessing risk appetite and risk tolerance is to start with the most basic of all notions: that risk can be best expressed as a future cost. The bot- tom line is that risk creates claims on income in a manner that might be seen as similar to interest expenses and overheads. But because risk claims are prospect- ive and contingent, cash-equivalent costs don’t initially appear on the books.
Subsequently, they do so when:
● Positions are liquidated, and
● Losses are written into the income statement.
Up to a point, the qualification (and quantification) of risk as a cost is possible if we have refined information elements going beyond transaction pricing and cap- ital allocation. This information should treat risk as a dynamic entity that changes rapidly over time, using market prices to steadily calibrate exposure to:
● Market factors
● Credit factors, and
● Other critical risk factors (Chapter 9).
Traders and investors who are serious about risk management, and therefore about the job they are doing, concentrate on finding strengths and weaknesses in the market, and in the instruments in which they trade, as well as in the com- panies behind these instruments. ‘Financial reporting is about more than just market pricing. We attach a lot of importance to stewardship and governance,’ a senior analyst said.
Alert investors not only want to understand the facts affecting market behav- iour, but also to appreciate future costs due to risks they have being assuming.
Seen in this perspective, a financial reporting system that fails to capture the requirement of stewardship – documented through monitoring past transactions, positions and events – would not be forward looking.
No matter what their risk appetite may be, people who don’t work hard enough to be ahead of the game find themselves among the losers. A surprising number of investors and traders dip in and out of the market, betting on just a 50:50 chance.
The worst possible investment mistake is the ‘going bust’ trade (section 5), which often results from a spur of the moment decision. There is probably
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no class of trades and investments with a higher failure rate than those pre- sented as ‘intuitive’ – for instance, committing to an unplanned position because somebody just recommended it. In contrast to a hit-and-run approach, the right homework in risk management means following clear enough guidelines:
● Assess and reassess one’s risk tolerance. The assessment of one’s own risk appetite and risk tolerance must be accurate not precise, since it is not pos- sible to kill two birds with one well-placed stone, and it must be properly documented. While the market is going north, it is easy to think one can handle riskier investments. But little by little the assumed level of expos- ure may be more than the investor wants to take, or actually needs, and much more than he or she knows how to handle.
● Lower short-term expectations to meet market reality. During the go-go 1990s, and similar periods in the past, many investors became accustomed to annual returns of 15–20% or higher. Not only is this well above the S&P 500’s historical average of 11% (from 1926 through to 2000), but it also translates into huge risk – hence future cost.
● Focus on the longer term and put a level of confidence on your projections.
This closely relates to choice of an investment horizon. It is always wise to keep an investment period, and the market uncertainty associated with it, in perspective. Volatility may be unpleasant, but it is not unnatural.
Investors who have the time, patience and discipline to do their homework with their investment programme and the positions they have taken, are rewarded in the longer run.