Risk Analysis
Risk Analysis: Technology Outstrips Firms' Abilities to Use It
Risk Analysis: Technology Outstrips Firms' Abilities to Use It
February 22, 2010
When I was first presented with the idea for this article, I thought to myself that the idea of "advances" in risk analysis and control was a given. I need only report on them and speculate in an informed way as to what advanced technologies had brought and still can bring to this field.
But as I drifted back to the word "advances" and thought back to the origins of applying information technology to risk management, I wondered if the state of risk management had truly advanced at a pace that was commensurate with the great leaps forward that technology had provided in general-and was still prepared to provide?
The answer was that technology advanced risk analytics far beyond financial services firms' abilities to use it. First, for its intended purpose, managing risk for it and its stakeholders' self interest, and second, for keeping a check on unexpected and financially damaging events in the interest of all participants in a healthy economic system.
THE FIRST FIFTY YEARS
Flash back to the start. My early recall of using technology for risk analysis was in the early 1960's when computers, then the first generation of all transistor-based mainframes, were used to calculate margins for futures contracts, then individual stocks, then options. After that, it got more complex, with options and equity portfolios, then options and futures, and eventually all manner of combinations of futures, options and securities, now referred to overall as portfolio margining.
Brokers and dealers collected these margins from customers to protect against market downturns creating defaults of customer obligations. In turn, each had to put up its own margin with clearing firms that, in turn, posted margin collateral with a centralized clearing house. Acting to mutualize the risk of any one customer or firm from defaulting, these clearing houses came to be insurance collectives of only the largest firms, guaranteeing each other from loss through a capital fund and layers of insurance.
Further innovation came in utilizing the vast data-crunching capabilities of large databases of historical price information emanating from equity and futures market centers. Where such data had not yet gotten automated, as in bond prices, ambitious academics and traders engaged in massive efforts to manually input the data so that they could back test theories of performance and risk. The 1980's junk bonds of Drexel Burnham Lambert were the first such set of back-tested products where future risks and returns were predicted from past data points. Over nearly five decades of advances, calculations progressed from batch processing overnight to instant processing, in what is now known as "real time.''
By the time Michael Douglas and Charlie Sheen squared off in "Wall Street" on film, also the same year, 1987, of the famous "market break" handheld devices had evolved from the portable calculators of the 1970's to infrared and radio-frequency-enabled palm-size computers which, in turn, would lead to smart wireless devices.
These were used initially on options exchange trading floors, making risk calculations more mobile by calculating options prices and measures of changes in prices, time and volatility known as the "Greeks." These calculations were used by floor market makers to help hedge options trading risks on the fly. Later devices were able to interact with market data feeds on intersecting and interrelated assets and contracts and to calculate-in real time-opportunities to arbitrage prices amongst and between mathematically correlated stocks, bonds, exchange-traded funds, options, futures, option futures, indexes, and baskets of cash and/or synthetically structured products. Again all of this progressed over a half century.
