What is Risk

How the New Yorker's Atul Gawande Caused the debacle at UVA

"What's the difference between a risk and a gamble? You can rescue yourself from a risk. If a gamble goes wrong, the consequences are irrevocable. I first learned this distinction from a battalion commander who had served several tours in Afghanistan. I interviewed him for a series of articles I wrote about risk."

That quote is from John Dickerson of Slate discussing the firing of UVA President Theresa Sullivan.  Apparently the plot to unseat Sullivan was hatched by UVA rector  Helen Dragas.  While trying to convince other decision makers to back her coup attempt she provided the transcript of a commencement address by Atul Gawande.  In his address to Williams College graduates Gawande had discussed risk, failure, and recovering from failure.  Dickerson suggests that perhaps Dragas had missed the point of the Gawande's speech - the importance of being able too rescue oneself when a risk goes wrong.  Dragas's plan did go wrong (as protests broke out until Sullivan was reinstated) and Dragas and her co-conspirators had not planned for that eventuality.  While discussing Dragas et als mistake Dickerson makes the above comparison between risk and gamble.

I am going to show my ignorance here - I am a risk manager by profession and I have never heard this definition of risk versus gamble before and frankly it sounds strange to me.  However when I started thinking about why it was wrong I realized that "risk" is a hard word to define - possibly because the word is used in multiple ways.

Let's see what Websters has to say

"risk noun \'risk\

1 possibility of loss or injury: PERIL

2 someone or something that creates or suggests a hazard

3a: the chance of loss or the perils to the subject matter of an insurance contract; also: the degree of probability of such a loss

3b: a person or thing that is a specified hazard to an insurer

3c: an insurance hazard from a specified cause or source <war risk>

4: the chance that an investment (as a stock or commodity) will lose value"

 I don't think that any of the other definitions really express the word risk in a way that I know it.

Let's see what Wikipedia has to say

"Risk is the potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome). The notion implies that a choice having an influence on the outcome exists (or existed). Potential losses themselves may also be called "risks". Almost any human endeavor carries some risk, but some are much more risky than others."  

Wikipedia also provides a number of alternative definitions of "risk" prefaced by  "The many inconsistent and ambiguous meanings attached to "risk" lead to widespread confusion and also mean that very different approaches to risk management are taken in different fields."  Ok so that may explain why I have trouble defining "risk".  It appears that there are multiple manners in which the word "risk" is used. 

First "risk" can be used as a synonym for probability or hazard.  As in "what is the risk of getting hit by a truck?"   In this case we assume that the implication of the event occurring is very negative and the word "risk" just denotes the probability of the event occurring.  Furthermore when used in this context there are usually phrased as there being two distinct possibilities - getting hit by a truck or not getting hit by the truck.

Second "risk" can refer to a listing of possible bad states without assigning probabilities to them.  An example would be "What is the risk if you were to contract the flu?"  In this case the reference is not to the probability of the event occurring but rather to what the possible outcomes are.   If you are healthy then the "risk" is that you feel crappy, or be in bed for a week, whereas if you have a compromised immune system the "risk" of catching a flu is that it could be fatal. I guess one could attach probabilities to each possible outcome conditional on the initial health status of the person in question but that would be an atypical response to the question.

But how do the above uses of the word "risk" apply to this statement "what is the risk of holding one share of IBM stock for a week".  Well obviously the "risk" is that the price of the stock could drop but that is pretty uninformative.  Someone who asks that question wants to know how much the price of IBM could fall and what probability you would assign to each of those falls.  Just saying how much the price of IBM could fall is nearly tautological.  It "could" fall to zero but that not likely.  So this use of the word "risk" asks for both the possible outcomes as well as the probability of each occurring.  

The case of getting hit by a truck is really just a special case of this third meaning of "risk".  And it is one where the "risk" is easy to understand since there are only two outcomes.  But once we start assigning probabilities to multiple outcomes then "risk" becomes difficult to define.  Is "risk" the probability of the worst possible case? or the probability of being significantly worse off? or the probability of being any any worse off?  should every outcome get the same weighting?  We could present the "risk" as a distribution over possible outcomes - for example the left hand tail of a t-distribution with mean of 0.5% and standard deviation of 5% and 3 degrees of freedom.  That fully enumerates the probabilities of different negative outcomes but does it tell us what the "risk" is?  That tells us what the probabilities are.

I think of risk as having three distinct parts (1) a set of possible outcomes (2) a probability distribution over those outcomes (3) and a valuation or utility measure which assigns a value to each possible outcome.  Assuming the outcomes are distinct we can then construct a single measure of the "risk" of any situation by summing over the probability weighted valuations of the outcomes - similar to expected utility.

For example one possible valuation could be assign 0 to any outcome except the worst and assign 1 to the worst possible outcome.  Weighting each valuation by its respective probability and summing over our measure of risk would then be the probability of the worst case outcome.  There are literally an infinite number of possible weighting schemes one could come up with for different outcomes.

Now back to Dickerson's statement.  "What's the difference between a risk and a gamble? You can rescue yourself from a risk. If a gamble goes wrong, the consequences are irrevocable."  I don't see anything in the definition of risk which alludes to the ability of one to rescue oneself or not.  The point of his article may be correct but that is not the definition of risk.

ACA fallout

I wonder what percent of those who oppose the ACA and specifically the individual mandate can explain why it is unconstitutional?  Under our Supreme Court's current interpretation of the Constitution what precedent does this law violate?  Likewise I wonder what percent of those in favor of ACA and the individual mandate can explain why it is constitutional.  Obviously our legal system doesn't place equal burden on both sides of the argument.  A law is a priori assumed to be constitutional unless and until the courts say it is not.   (Pre-clearence by some states of voter laws is the one possible exception that I know of).

Furthermore, I would bet that 99+ percent of those who hold an opinion on the constitutionality of the ACA aligned themselves on the issue entirely independent of the constitutionality issue.  Rather they picked a side and that drove whether they felt the law was constitutional.  How many people (other than a few law professors) care whether the ACA is constitutional under the Commerce Clause or under the Federal governments right to tax authority?   Mitt Romney obviously didn't have a problem with the constitutionality of the individual mandate back in 2007  when he imposed it in Massachusetts.  Yeah that was a cheap shot...but I had to get it in somewhere.

Before I leave this topic - this one and this one are kind of funny as well.

Political Tribalism

Unpopular Mandate :  Why do politicians reverse their positions

This New Yorker article discusses the changing political support for Obama-care's individual mandate .  The mandate started out as a Heritage Foundation proposal in 1989.  In 1991 it was put forward as part of a Republican alternative to Clinton-care with eighteen Republican co-sponsors.   It was later enacted at the state level by then Massachusetts Gov. Romney.  Now every Republican in the House and Senate as well as Presidential Candidate Romney claim it is unconstitutional. 

The article discusses experiments which show that whether a person supports a particular piece of legislation is more dependent on that person's party identification and which party put forward a bill rather than the actual content of the bill.  I don't find that altogether irrational though.  Figuring out what a bill actually says and what its impact will likely be can often be extremely difficult.  Most people have other things to do all day than read legislation and furthermore most of the public doesn't have a theoretical framework or knowledge of empirical evidence enough to put complicated legislation into context.  That may sound elitist but it is not saying that public is stupid rather they just don't have that training.  Perhaps it is a bit different on social issues.  But how many people could tell you what the impact of reducing the capital gains tax will be on capital formation?  Party identification of a bill acts as a shortcut to whether a piece of legislation  is likely to be something a person would support or not.   It is tribalistic but it is not wholly irrational.

However the case of how the public uses party identification seems a bit different than the case where elected officials completely change their opinion on the constitutionality a bill.  Either you think something is constitutional or you don't.  One would hope that if a politician is proposing a bill they have some idea what is in a bill, some idea of what its impact would be, and if it is constitutional.  One would hope..

Crude Intentions

Whenever retail gasoline prices spike it is big news.  But you don't hear much mention when they start to come back down again.  We are entering driving season and US retail gasoline prices are nearly $0.50 off their highs of last March   1 Year Chart.    Since 2007 World Petroleum consumption is up 1.8MM bpd (2%) while world oil production is up 2.7 MM bpd.    The US, Europe, and Japan are together using 3.6 MM less bpd than they were in 2007.  The big gainer is China who is using 1.4 MM more bpd than in 2007.  Other big gainers are India +0.600 MM bpd and Saudi Arabia +0.800 MM bpd.  Saudi seemed surprising until you realize that they burn crude oil to generate electricity.  Checking todays NYMEX settles, the crude oil forward curve is essentially flat from Feb 2013 through  the end of 2018.  Either the world is predicting a lot of new production coming on line in the next decade, or they see a lot of substitution away from crude, or they are not predicting much growth for next decade.  Btw for all of those predicting that the Fed's stimulus will generate huge inflation - the crude oil market is not seeing it any more than the TIPs market is.

Forb-age

I never really read Forbes magazine.  I just never found their type of business journalism interesting.  It seems to be more a celebration of wealth than a serious inquiry into what makes the economy tick.  I very much like like Bloomberg Magazine and Bloomberg online coverage.  I like the Wall Street Journal reporting and the New York Times business section.  I am even willing to read the WSJ editorial page.  While some of it is nutso other articles do present a serious defense of conservative ideas.  I like the breadth of international coverage of the Economist although I don't really like their writing style.  And I find their policy prescriptions to be of the "if all you have is a hammer then every problem looks like a nail" sort.

I never really had anything against Forbes Magazine - I just didn't find their articles interesting.  When I think Forbes I think Steve Forbes.  He seemed to be a pleasant sort of guy who was willing to poke fun at himself.  To be fair he is one of those kooky Larry Kudlow, Club For Growth, supply side true believers.  Cut taxes for the wealthiest Americans and despite all evidence to the contrary we will experience an enormous burst of economic growth which will solve all of our problems regardless of the situation.  And while you are at it go onto the gold standard.  But I have nothing really against his magazine....until....today I just happened to see this article on Google.  Forbes   I think I will keep skipping Forbes Magazine.

If You Can't Gut the Law ..Then Gut the Enforcement

 House panel sticks with CFTC funding cut  

"(Reuters) - On a party-line vote, the House Appropriations Committee voted for a 12 percent cut in funding for the U.S. futures regulator on Tuesday, moving a step closer to a showdown with the Senate, where a large increase is proposed....Committee chairman Hal Rogers said the CFTC budget was up 80 percent from 2008 and the agency did not need more funding. "It just seems to me this is a big-time waste of money," said Rogers, Kentucky Republican, of proposals for more funding."

The dealer banks don't want derivatives to be forced onto exchanges as per Dodd-Frank.  Since it does not look like the bank's allies in the House will be able to overturn Dodd-Frank the one thing they can still do is to defund the agency who will be responsible for enforcing the new policies.  The CFTC is already underfunded.  To add more responsibilities to their plate while cutting their funding is...well nearly criminal in itself.

The truth is that strong regulation helps the futures (and securities) industries remain viable.  If end-users believe that there is potential for manipulation in a market then they will not want to trade in that market.  The less people trade in a market the less liquidity there is and the higher are the costs.  The two big advantages of the futures industry are (1) the large pool of liquidity (2) the central counter party and clearing credit model.  Taking either of these away hurts the industry.

If the Tea Party and the Occupy Wall Street crowds really want to ensure that we the taxpayer do not end up bailing out the big banks again then the best things that they could do are (1) make sure there are strong laws in place to regulate the futures, securities, and banking industries and (2) make sure that the agencies in charge of regulating these industries are properly funded for the size of their task.

Not Worth the PDF It's Printed On

MF Global Client Protection

"For All Futures Customers of a U.S. FCM Trading U.S. Futures or Options:  Section 4d(a)2 of the Commodity Exchange Act provides that a U.S. FCM must keep all money, securities and property of its customers use to margin futures or options trades on U.S. exchanges and all monies accruing to its customers as a result of such trades segregated from the funds of the FCM.  CFTC Regulations1.20 and 1.30 provide specific requirements for the handling of customer funds."

Some Things Never Change

If I were to open Google News for 525 BCE would the top four stories have been about Greece, Egypt, Persia, and the going's on in Tyre and Damascus?

Will Mitt Romney Have His Membership in The Axis of Incoherence Revoked??

Romney:  Spending Cuts Slow Economic Growth

Well this was positive - or it was until his spokesman backed away from it.  But I think it shows that he understands basic macroeconomics.  However, it brings to mind a question:  if decreasing government spending decreases growth, then shouldn't increasing government spending increase growth?  Actually I would guess that even during a liquidity trap there is probably a government spending equivalent of the Laffer curve.  Zero government spending leaves you with little growth.  Increasing government spending increases growth up to a point.  And after that point further increases in government spending decrease growth.  But where are we relative to the peak right now?  Is Romney suggesting that we are near the peak?  Maybe the Laffer curve is the wrong analogy.

Is It Not Registering?

Loophole at MF Global is Headache for Regulators

I find this really quite astounding.  The gist of the story is that most of the executives at MF Global who have been implicated in the misplacement of funds were not registered with the National Futures Association (the SRO for the futures industry).  Hence they cannot be cited for failure to supervise.  Jon Corzine was registered but his direct involvement with the cash transfers is in question.   However, Bradley Abelow (COO), Laurie Ferber (General Counsel), Henri Steenkamp (CFO), Vinay Mahajan (Treasurer), and Edith O'Brien (Assistant Treasury in charge of approving cash movements) were not registered with the NFA.

After reading through the rules of the NFA - it appears that every member firm must have a at least one registered supervisory principal - however it does not appear to require that all persons who are in supervisory roles be registered principals.   I suspect that rule will be changed soon.

NFA manual

MF reporting

I am generally a big fan of Frontline’s documentaries however I didn’t think that their story on the demise MF Global was particularly enlightening.  Perhaps I am already familiar with how the industry works and having followed the MF Global situation closely their story did not provide me with any new information.

I wonder if my enjoyment of Frontline is in part due to knowing very little about the topics of most of their stories.  If I knew more perhaps I would have the same reaction that I did to their MF Global story.  Or maybe it was just weak reporting on their part.

On the other hand Fortune Magazine has done a very good in depth piece detailing the last days of MF Global.

I know that I am not the first to notice the irony - but Jon Corzine seems to have forgotten the lessons of  Long Term Capital Management.  LTCM made huge bets on small convergence trades.  When they started losing money each of their counter-parties demanded increased collateral, which forced LTCM to liquidate large and somewhat illiquid positions, which led to further losses, which led to increased demands for collateral and so on.  Goldman CEO Jon Corzine strong-armed the other major investment banks to lend LTCM more money and not increase collateral calls so they could liquidate in an orderly fashion.  And now thirteen years later MF Global CEO Jon Corzine is undone by a similar liquidity crunch.  Whoever the Greek god of finance is (is it Mercury?) s/he must have an ironic sense of humor.