Epsilon – the error in risk management
EFN 505 Financial Risk Management Essay and self-reflection due 12.4.2019
By Adam Atkins, student, QUT Masters of Business (Applied Finance) 2019
Essay: “Epsilon exposed: Getting down and dirty on risk!” The Soldier, The Gambler and the FX Trader.
Risk is an abstract concept that we seek to find ways to describe, analyse and attempt to measure and perhaps manage. At a more academic level we may discuss aspects of it such as exposure, vulnerability and chance of occurrence. The Value At Risk (VAR) method is popularised in finance. However there are criticisms of VAR that it is too short sighted and fails to mitigate black swan events that are not all that rare. Risk management at an intellectual level is in many respects rearward looking.
At its fundamental essence, risk is about whether or not an event or circumstance occurs or doesn’t occur, to what extent it occurs or not, and what the consequences or not of that are. Risk and opportunity are linked – volatility typically describes negative risk events, and opportunity typically describes positive risk events.
In volatility there is potential for opportunity much as in opportunity there is potential for risk. Epsilon (ε) is the Greek character designated as a measure of uncertainty and risk. In statistics it is called the error or unexplained term. In the real world many things are unexplained and some unexplained things are sometimes even attributed to randomness or luck.
Risk is more than simplified concepts of vulnerability and exposure. It requires the forward looking weighing up of the chance of outcomes actually occurring (or not), preparation and mitigation for the chance of outcomes occurring, the exposure and vulnerability if and when those outcomes occur (or not), and what the potential consequences are, given the same, and what if any mitigation is available.
This paper will argue that epsilon in warfare, gambling and financial markets presents both risk and opportunity, and that management of risk is not equally distributed.
War is an extremely hostile environment of friction, chaos, danger and thrills. The VAR can’t get much more real than death and defeat. Risk is in everything and everywhere. Risk seeking can mean losses but also risk aversion can mean losses. Both doing something and doing nothing will have risks and costs. Add to this other variables, the other side(s), your own side(s), nature and random chance all get a vote on this.
World War One 1914-1918 was one of the deadliest conflicts in human history. 10 million solders died, and millions more wounded and damaged. The most dangerous weapon used was indirect artillery – where not taking precautions like trenches, dug outs, bunkers and armour resulted in certain death, but also in taking precautions many still died. Armoured helmets were made mandatory after many avoidable casualties with troops wearing soft caps. Careless risk taking has severe irreversible consequences. War is a real skin in the game scenario, where if you lose the game, you lose your skin.
Captain Albert Jacka VC was a highly decorated and courageous Australian soldier. In World War One he was awarded at least one Victoria Cross and would have received another had he not been so Ill-disciplined including for insubordination. He was among the bravest and most successful and master of risk management.
In one famous engagement, his group were taking cover and their advance had stalled. Albert Jacka saw an opportunity, he estimated the epsilon, broke cover, leapt into action with his weapon and grenades, and personally defeated an enemy machine gun post. In his surprise action he then captured 100 enemy troops. This was an extremely risky manoeuvre but it was successful.
In succeeding in this action, Jacka saved the lives of his friends, and indirectly saved the lives of his captured enemies since they would live out the war as POWs. With all the risks, all the possible mitigations, with everyone else just trying to live another day, one brave man overcame his fear, managed the supreme risks and was victorious, on multiple engagements.
Jacka’s management of risk is not that he did not understand the risk, he certainly did, he appreciated that things either happen or they don’t, even if the odds are against you. There were many other brave men that didn’t make it. After the war Jacka didn’t do so well, ordinary life was too dull and he fell into obscurity.
We can appreciate from The Soldier that risk management is more than exposure and vulnerability, it is also about seizing opportunities, and appreciating that as rough and risky as things can be, a risk event either happens or it doesn’t.
I was recently in the Ipswich Country Club, a golf club with a pokies room. A gambler was there simultaneously running three different pokie machines of the same features. The gambler had inserted $100 into each machine, so his exposure was $300. I did not enquire into his personal circumstances but lets assume from his appearance he did not have another easy $300 handy if he needed it, so his vulnerability from a total loss is not insignificant to him.
The Gambler, in the space of about 15 minutes had doubled his initial stake from $300 to to $600. In running three machines he tripled his chances of any outcome ie a win (or loss) and at that point in time had been “lucky” with a positive outcome, even though the odds are against him in the long run. Watching on, I asked his strategy and if he would continue or cash out. He continued. About 15 minutes went by and his total sum was about $400. He cashed out at $363.
The Gambler was not an apparently sophisticated person, he was intuitive and had found a method that suited him. Without so much as verbalising his technique he appreciated that in the long run pokies will always win, but in the short run there are opportunities. He understood enough that the odds were against him but what he could do was manage (increase) his exposure to try maximise the chances of any short term win, and that the wins that did come on one machine would in his estimation outweigh the losses on another machine. On this occasion he succeeded in the short run.
The Gambler would have been better off cashing out earlier, but made a conscious decision to continue. The essential factor was whether or not a win occurred, the extent of that win, and what it cost the Gambler to get that win. On this occasion the Gambler failed to take the winnings when he doubled his stake which would have suited his strategy, but the overall the outcomes were positive.
We can appreciate from The Gambler that risk management is not always about averages and odds, but also about how the risk game is played. The odds can and always are be against you, but by understanding that the long run is always a loss, and that the pokie machines are designed to extend play time for as long as possible into that long term certain loss, then by playing the game to maximise short term wins and stopping when there is a sufficient win, this particular Gambler had unequal risk management to a typical pokies player.
The FX Trader
Foreign Exchange (FX) trading is high risk with high losses but also high gains. Currency markets are extremely volatile. A feature in over the counter (OTC) is high leverage and interest charges that compel a trader to take a short term approach since there are interest liabilities for holding positions overnight.
In March 2019 I observed the AUD/NZD currency exchange OTC market. Early in month, the rate was trending down but hitting resistance around 1.04000. On a fundamental view, I posited that the AUD was unusually low, and that a more median rate would be around 1.06000. If I was right, then the way to profit from this would be to go long. I communicated this research to a trader friend, who then used a simulated account to test. If the research is wrong, then The Trader will suffer a loss, and if it is right, a gain.
Sensitive risk events are expected to affect both the AUD and NZD exchange rates. A negative event for the AUD is expected to cause a sharp drop, typically followed by a downward trend until a new equilibrium is found. The same goes for the NZD, and vice versa with positive events and news.
Over the course of March 2019 Australian GDP and jobs figures were below consensus expectations, the RBA hinted at a more dovish outlook. These were negative events for the AUD. Further, the RBNZ was less dovish than the RBA, and NZ’s major commodity dairy and its products had a positive increase in price. These were positive events for the NZD. Also happening at this time the USD strengthened and this had downward pressure on both the AUD and NZD, but to unequal amounts.
Consequently the AUD/NZD fell to as low as 1.02850 at the lowest spike down. In the short term, the research was out by -0.01150.
If a real life trade had been done, a typical trader may have used risk management strategies such as a stop loss and been “stopped out” automatically or manually cut their losses. For a severe loss they may be forced to close out their position sooner, such as at 1.03700 or 1.03400. If a stubborn trader had held on to 1.03 or lower when they are clearly out of the money, they may have blown up their account. Running a simulated account, trading margin limits is not as real a problem as a live account. But still no-one wants to lose even dummy money let alone real money. The trader continued with the high conviction that the AUD/NZD was undervalued and elected to increase their position, effectively doubling down. The believed the epsilon factor meant that the market had failed to correctly price the AUD/NZD, and the market was incorrectly following a trend.
At last checking the AUD/NZD was 1.06. Had real money been used, there could have been a short term -0.01150 loss at 1.02850 but after 6 weeks, at 1.06000 it would be a 0.02000 gain on the first position, and a 0.03000 gain on the doubled down position. If the simulation had been real, then without risk management the loss may have blown up a normal account, but with active management and the decision to buy into a losing position, much bigger profits were realised. However consider if there was a flash crash, or sharp drop again.
Risk can mean that even when you are right, the poor risk management still means you can lose and be forced to close positions. The trader made a risky call to increase their position, and in doing so realised a profitable opportunity albeit with simulated money. Good risk management increases returns but it could also go either way. The Trader was effective at risk management.