Disclaimer: The opinions of the columnists are their own and not necessarily those of their employer.
C. Warren Axelrod

The Meaning of Risk, the Universe, and Everything

The title of this column paraphrases the question “What is the meaning of Life, the Universe, and Everything?” asked of the mega-computer “Deep Thought” in Douglas Adam’s book, The Hitchhiker’s Guide to the Galaxy. After 7 ½ million years of calculation, the computer came up with the answer “42.” When confronted with the meaningfulness of the answer, Deep Thought surmised that perhaps it didn’t quite understand the question. You can view this hilarious revelation at http://www.youtube.com/watch?v=x2rS-ha8DbE

The Deep Thought scene came to mind with the recent disclosure by JP Morgan Chase of a trading loss of at least $2 billion from trades relating to Credit Default Swaps (CDSs), the same general category of derivatives as contributed to the 2008 global financial meltdown. Why is it that the most sophisticated of risk management groups periodically, and seemingly inevitably, gets caught with debilitating losses from such trading? In JPMC’s case it appears that the main impact of the losses will not be on the long-term financial health of the institution, but on the introduction of more stringent laws and regulations by the U.S. Government.

While unrealized losses and gains must be reported regularly, risk models generally look to long-term returns, which can lead to both large profits and large losses. However, when a large loss occurs, everyone seems to forget the huge profits that may have preceded the losses and which may have accounted for net profits that are still significant, even having taken the losses into account. From my experience, commercial banks are looking for steady positive returns and cannot deal with volatility that can bring about big losses (the enormous profits don’t seem to be much of a problem). On the other hand, the culture of investment banks is more tolerant of occasional losses, as they look to a healthy return in the long term. These two banking cultures are so different that the form, structure and attitude of financial institutions have significant impact on how they deal with trading gains and losses.

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