Carol Loomis is a legend. Her columns in Fortune are a collector's item and I have been a collector since 1994 – the year in which I started out my career in investments.
In March 1994, Loomis wrote an article on derivatives in Fortune titled "The Risk that Won't Go Away". I was totally blown away after I read that article. At that time, derivatives were the talk of the town. There was an explosion in the usage of derivatives, particularly, non-traded ones, which ostensibly enabled companies to “manage risk” at a low cost.
Loomis however took the opposite view and predicted trouble ahead. And sure enough, trouble followed soon after, when several derivatives-related financial fiascos like those at Bankers Trust, Gibson Greetings, Orange County, and P&G emerged. These were covered by Loomis a year later in March 1995 in a column titled "Untangling the Derivatives Mess" which essentially said “I told you so”.
What is the connection between the law of conservation of energy and the concept of risk in financial markets?
In my view, there’s a big connection. I feel that they are essentially the same – an insight I got after reading the above Loomis’ columns although she herself did not talk about the connection.
The law of conservation of energy states that the total inflow of energy into a system must equal the total outflow of energy from the system, plus the change in the energy contained within the system. In other words, energy can be converted from one form to another, but it cannot be created or destroyed.
Simply change “energy” for “risk” and you’ll have the law of conservation of risk.
The law of conservation of risk states that the total inflow of risk in a system must equal the total outflow of risk from the system, plus the change in the risk contained within the system. In other words, risk can be converted from one form to another, but it cannot be created or destroyed.
Take the simple example of a hedging operation involving shorting index futures. The hedger who shorts the index futures is trying to protect herself from a market decline. Should the market decline, the value of her stock portfolio will also decline, but this decline is expected to be offset by the profit she will make on the short futures position. So far, so good. But, is it?
Is it really that simple? Has the risk to the hedger been reduced? Of course not. The risk of the decline in the price has merely been transferred to the buyer (counter-party) of the index futures. But that’s not the whole story. There is more to it.
By selling the index futures, the hedger has transferred the price risk to the buyer of the index futures but has assumed another risk. That risk is credit risk i.e. the risk that the counter-party may default.
While it’s true that with the presence of organized futures markets with margin requirements and other risk mitigation measures in place, credit risk is much lower at the individual level, this does not mean that the risk in the entire system has been reduced. At the individual level, risk may be reduced but not at the system level.
Risk can be sliced and diced. Risk can be transferred from one person to another. And one form of risk might replace another form, but at the end of the day, the total risk in the system is not going to change.
In other words, just like energy, risk can be converted from one form to another, but it cannot be created or destroyed.
And that’s one insight that has paid me well over the last eleven years…
