In this new world of enhanced risk awareness, investors need to find ways of factoring in very unlikely, but high impact events. However, this approach does not come naturally as it goes against the status quo of reacting to events as they occur. Notwithstanding, there is substantial merit in developing a robust defence against extreme risks through combining a qualitative understanding, quantitative modelling and a cost-benefit analysis of possible strategies. This involves developing a qualitative understanding by asking what could cause certain events, whether they are plausible and what the consequences could be, and then to consider the investment risks, the impact on asset returns and, in some cases, liabilities.
As a start, we have identified 15 main extreme risks which, while very unlikely, would impact economic growth and asset returns.
Financial extreme risks revolve around solvency and whether a financial institution is able to pay its debts with available cash. In the interconnected modern financial system, high levels of leverage mean insolvency for one institution can quickly become a systemic problem. The primary triggers for financial risks are falling asset prices and incomes, or they can be generated by a recession in the real economy and transmitted to the financial sector through a default on loans. The extreme risks included in this category are: excessive leverage, banking crises and insurance crises.
Economic extreme risks are less homogenous than the financial risks and range from a deflationary depression to hyperinflation and a return to a gold standard. The deflationary depression risk implies government actions will prove incapable of returning the economy to sustainable growth, while the other economic risks essentially assume government actions are successful, but at a price. The other economic extreme risks are currency crises, sovereign default and the end of fiat money.
The third category of extreme risks derive from politics, but include climate change and killer pandemics, and as a consequence are much harder to monitor and predict. In most cases these will be hard to hedge. Other extreme risks included in this category are the end of capitalism, political crises, disunity in Europe, major war and protectionism.
Having identified a risk category, the next challenge is to determine the likelihood and impact. This is difficult because of infrequent occurrence and few historical observations, so quantitatively derived probabilities would give the appearance of accuracy but be prone to large errors. We use historical data to inform a subjective allocation of each risk to one of three probability categories. The risks are also placed in an impact category and we also use a subjective scoring system to derive a ranking. This ranking serves as a priority list for considering the various risks and whether any portfolio hedging activity could or should be undertaken.
Not all of these extreme risks are hedgable and any hedge used is likely to be very imprecise. A starting point for deciding how effective the hedge needs to be can be based on how much loss is acceptable – the more loss that is acceptable the easier it is to hedge smaller proportions of
the portfolio. More complete hedging increases complexity and is almost certain to require the use of derivatives, so thought needs to be given to whether the counterparty would be willing and able to pay out should that extreme event happen. On the positive side, derivatives provide much greater flexibility and the more precise targeting of risks, and don’t require much capital, which leaves the bulk of the portfolio untouched.
It is clear there are numerous extreme risks that could interrupt future growth, with assets faring differently depending on the event. Some events are easier to understand and the consequences are more predictable than others. Of all of them, public policy issues should be considered above others as they will both influence the risks and be shaped by the shifting likelihood of the different risks through time. If nothing else, once aware of risk in the extremes, planning an appropriate and implementable defence should be common sense for those in charge of assets.
Tim Hodgson is senior investment consultant at Towers Watson.
