risk and return in rapidly chkhanging markets and return in rapidly chkhanging markets edward...

Risk and Return in Rapidly h kChanging Markets

Edward FishwickManaging DirectorGlobal Co-head Risk & Quantitative Analysis

Lesson 1: The Paramount Importance of Liquidity

Liquidity is the life blood of a modern economy.

The ability to meet immediate obligations is critical to financial The ability to meet immediate obligations is critical to financial survival.

Many market participants assumed that liquidity was a fact of lifey p p q y f f frather than a special condition.

• Continuous time finance is, after all, just an abstraction, not a guarantee.

2The opinions expressed are as of June 5, 2009 and may change as subsequent conditions vary.


Maximizing wealth, assuming efficient markets exists, permits liquidity concerns to be addressed as an afterthought.

• Value can be extracted from portfolios through the mechanism of the market.

The folly of “wealth maximization”

• In the absence of functioning markets, cash may not necessarily be generated from wealth.

• Alternatively, the cost of doing so becomes exceedingly onerous.y, g g y

Bonds are much better than you think.

• Reliable cash flows should be used to meet critical future liabilities.

• If the portfolio contains cash or cash producing securities, liquidity can be extracted relatively efficiently.

3

The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments.


Free Riding: when market participants anticipate liquidity, investors can trade products they do not fully understand.

• Arbitrage and relative value trading preserve the intrinsic value• Arbitrage and relative value trading preserve the intrinsic value.

Severe disruptions in a complex and opaque product space may hit expert investors the worst since they will tend to have concentrated expert investors the worst since they will tend to have concentrated exposures.

• The more complex the product, the fewer genuinely expert investors exist.Non expert investors will pass on “cheap securities” to avoid “poisoned • Non-expert investors will pass on cheap securities to avoid poisoned chalices.”

• As a result, the only bids, if any, come from vulture investors who will pay prices that are “too cheap to be wrong.”

Just being smart is not enough!

4

Lesson 2: Assumptions are just Assumptions

Mean-variance; iid• Volatility

• Correlation

• Higher moments zero

Zero means

T-series structure • Stationary

• Slow evolution

R gi• Regimes

Linearity

5


90

VIX

60

70

80

40

50

60

20

30

0

10

2/19

90

1/19

90

0/19

91

4/19

92

3/19

93

0/19

94

8/19

95

6/19

96

5/19

97

1/19

98

0/19

99

5/20

00

4/20

01

3/20

02

2/20

03

0/20

04

5/20

05

2/20

06

1/20

07

9/20

08

6

01/0

2

12/3

1

12/3

0

12/2

4

12/2

3

12/2

0

12/1

8

12/1

6

12/1

5

12/1

1

12/1

0

12/0

5

12/0

4

12/0

3

12/0

2

11/3

0

11/2

5

11/2

2

11/2

1

11/1

9

Source: FactSet


90

VIX

60

70

80

40

50

60

20

30

0

10

2/19

90

1/19

90

0/19

91

4/19

92

3/19

93

0/19

94

8/19

95

6/19

96

5/19

97

1/19

98

0/19

99

5/20

00

4/20

01

3/20

02

2/20

03

0/20

04

5/20

05

2/20

06

1/20

07

9/20

08

7

01/0

2

12/3

1

12/3

0

12/2

4

12/2

3

12/2

0

12/1

8

12/1

6

12/1

5

12/1

1

12/1

0

12/0

5

12/0

4

12/0

3

12/0

2

11/3

0

11/2

5

11/2

2

11/2

1

11/1

9

Source: FactSet


90

VIX

60

70

80

40

50

60

20

30

0

10

2/19

90

1/19

90

0/19

91

4/19

92

3/19

93

0/19

94

8/19

95

6/19

96

5/19

97

1/19

98

0/19

99

5/20

00

4/20

01

3/20

02

2/20

03

0/20

04

5/20

05

2/20

06

1/20

07

9/20

08

8

01/0

2

12/3

1

12/3

0

12/2

4

12/2

3

12/2

0

12/1

8

12/1

6

12/1

5

12/1

1

12/1

0

12/0

5

12/0

4

12/0

3

12/0

2

11/3

0

11/2

5

11/2

2

11/2

1

11/1

9

Source: FactSet

Lesson 2: Assumptions Are Just Assumptions

25.00

Monthly Cross-Sectional Volatility – FTSE350

20.00

10.00

15.00

5.00

--

01/1

989

01/1

990

01/1

991

01/1

992

01/1

993

01/1

994

01/1

995

01/1

996

01/1

997

01/1

998

01/1

999

01/2

000

01/2

001

01/2

002

01/2

003

01/2

004

01/2

005

01/2

006

01/2

007

01/2

008

01/2

009

9

31/

31/

31/

31/

29/

31/

31/

31/

31/

30/

29/

31/

31/

31/

31/

30/

31/

31/

31/

31/

30/

Source: FactSet; FTSE


0.8

Trailing 60 Day Correlation – Momentum & Value

0.4

0.6

0

0.2

-0.4

-0.2

-0.6

2/01

/200

7

6/01

/200

7

0/01

/200

7

3/02

/200

7

7/02

/200

7

3/03

/200

7

7/03

/200

7

0/04

/200

7

4/04

/200

7

8/05

/200

7

2/05

/200

7

5/06

/200

7

9/06

/200

7

3/07

/200

7

7/07

/200

7

1/07

/200

7

4/08

/200

7

8/08

/200

7

1/09

/200

7

5/09

/200

7

9/10

/200

7

10

02 16 30 13 27 13 27 10 24 08 22 05 19 03 17 31 14 28 11 25 09

Source: FactSet; Barra; BlackRock


LEVERAGE0.050

220 Day Cumulative Returns to Barra Factors From June 30, 2007

0.020

-0.010

-0 070

-0.040

-0.100

-0.070

11

0 50 100 150 200 250



LEVERAGE

0.020

0.050VALUE

0.020

0.040

US: Leverage US: Value

220 Day Cumulative Returns to Barra Factors From June 30, 2007

-0.040

-0.010

-0.040

-0.020

0.000

G0.020 0.020

-0.100

-0.070

0 50 100 150 200 250-0.080

-0.060

0 50 100 150 200 250

LEVERAGE

-0 010

0.000

0.010

VALUE

0 010

0.000

0.010

0 0 0

EUR: Leverage EUR: Value

0 040

-0.030

-0.020

0.010

-0.030

-0.020

-0.010

12

-0.0400.000 50.000 100.000 150.000 200.000 250.000

-0.0400.000 50.000 100.000 150.000 200.000 250.000


Lesson 2: Assumptions are Just Assumptions

• Serious risk managers always understood the limitations of models

• Model based forecasts require assumptions - Mean-variance;

volatility; correlation; etc

• It was always understood that these could be violated in practice

• But the last 2 years show this is at levels previously unimagined

- Rapidly varying volatility (absolute & relative)

Diversification works until it doesn’t - Diversification works until it doesn t

- Persistence or trending makes the measurement of risk horizon

dependant p

• Highlights the need for caution in the use of models, and expert

judgement in their interpretation and use

13

Lesson 3: Garbage (or Worse) In/ Garbage Out

I t d t b h d d d l i l Investors need to be more hands-on and develop a visceral understanding of the origination processes and borrowers.

Recently, the quality and performance of underlying assets were materially worse than expectedmaterially worse than expected.

• The underwriting process was much worse than ever indicated in the data.• Originators created loans primarily for sale and retained little, if any,

interest in their ongoing performanceinterest in their ongoing performance.

Going forward, investors will need to get more deeply involved in the information cycle.

• Relying on ratings alone was a failed strategy.

• Previous default and delinquency data was artificially low because, for a while, increasingly attractive lending terms masked defaults with refi’s.

• Even using a more rigorous analytical approach based on taking historical performance data and building and relying only on statistical models and stress test is insufficient.

B tt Li M i St t l d W ll St t

14

Bottom Line: Main Street played Wall Street.The opinions expressed are as of June 5, 2009 and may change as subsequent conditions vary.

Lesson 4: The Sources of Market Risk are Changing

US Treasury’s Financial Stability Plan:• Financial Stability Trust

— A comprehensive stress test for major banks

Canadian Government Support:• Given the low level of the target overnight rate, the

Bank of Canada is refining its approach in providing dditi l t ti l if i d th gh

Global Government Support

p j— Increased balance sheet transparency and disclosure— Capital Assistance Program

• Public-Private Investment Fund ($500 bn - $1tr)• Consumer and Business Lending Initiative (up to $1tr)

— Term Asset-Backed Securities Loan Facility (TALF)

additional monetary stimulus, if required, through credit and quantitative easing

UK Government Quantitative Easing and Asset Purchases:• Program of asset purchases, including corporate bonds,

commercial paper, and gilts, totaling £75 bnUK Government plan to guarantee up to £20bn:Term Asset Backed Securities Loan Facility (TALF)

• Transparency and accountability agenda• Affordable housing support and foreclosure prevention plan• A small business and community lending initiative

Troubled Assets Relief Program (TARP):• Allows the US Treasury to purchase or insure up to $700 bn

• The £20bn guarantees loans to small and medium-sized firms

UK Government nationalizes:• UK government called for the complete nationalization

of Lloyds and Royal Bank of Scotland• Allows the US Treasury to purchase or insure up to $700 bn of “troubled” assets from banks and other financial institutions

Obama’s $775 bn Stimulus Plan:• Aid the economy through tax rebates, mortgage assistance,

public spending, etc.Homeowner Affordability and Stability Plan (HASP)

French Government:• Pumps €6bn into ailing auto industry

Japanese Buy-Back Program:• The Japanese Ministry of Finance is conducting two

buy-back programs of Japan Government Bond –Inflation Linked (JGBi) and Japan Government Bond Homeowner Affordability and Stability Plan (HASP)

• Help homeowners refinance and modify mortgagesConservatorship of FNMA and FHLMC:

• $400 billion commitmentFederal Reserve Agency MBS Purchase Program:

A i l $160b i i f J 5 h

Inflation-Linked (JGBi) and Japan Government Bond Floating Rate Note (JGB FRN)

Australia’s AUD $47bn Stimulus Package:• The package includes AUD $29bn for infrastructure

projects and AUD $13 in cash handouts to low to middle-income groups.

15

• Approximately $160bn in transactions from January 5th to February 25th

Source: BBC News


Fed Purchase Program Expansion

Agenc MBS P rchases from $500 billion

Gross Demand is Expected to Exceed Supply in 2009*

Fed Balance Sheet Expansion

• Agency MBS Purchases from $500 billion to $1.25 trillion

• Agency Debenture from $100 billion to $200 billion

• Longer-Term Treasuries $300 billion

Net Demand is Expected to Far Exceed Net Supply in 2009*Breakdown of Adjusted Monetary Base & Liquidity Facilities

16

Source: Federal Reserve, Treasury, Banc of America Securities-Merrill Lynch; *2009 numbers are estimates; Source: Credit Suisse (US Mortgage Strategy), Federal Reserve, Freddie Mac, Fannie Mae, Treasury


As more power over the financial system shifts to global political capitals, market dynamics may shift from economic fundamentals or market technical conditions to political considerationsor market technical conditions to political considerations.

• Developed markets may become more like emerging markets.

Risk management teams may rely less on economists and Risk management teams may rely less on economists and statisticians and more on politically-oriented analysts.

• Quants may find themselves getting traded in for politicos.

The longer term impact on productivity from an increase in political control over the economy is not known.• If history is to be believed the prognosis is not positive• If history is to be believed, the prognosis is not positive.

17The opinions expressed are as of June 5, 2009 and may change as subsequent conditions vary.

Lesson 5: You Can’t Cram for a Crisis

Effective risk management is an expensive long term investment.

• Professional risk managers with substantive subject matter expertise are iti l t h i tcritical to have impact.

Analytics and information management technology are required for a reliable “information utility”.

• Organizations need to prevent internal “information wars”.

• Accessing and using information must be fast and easy.

How Can You Manage the Black Swan? How Can You Manage the Black Swan?

• Having a team and an efficient information infrastructure in place will allow an organization to respond to unanticipated issues or challenges.

• While every potential contingency cannot be anticipated, a comprehensive database of portfolio holdings and their characteristics facilitates a fast response.

18

• Risk mitigation is a critical part of risk management.

The opinions expressed are as of June 5, 2009 and may change as subsequent conditions vary.

Lesson 6: Unconditional Risk Doesn’t Matter Much!

2.00E-02

2.50E-02 US “Quality” US “Quality” –– 1973 to Date1973 to Date

1.00E-02

1.50E-02

0.00E+00

5.00E-03

1 50E 02

-1.00E-02

-5.00E-03

-2 50E-02

-2.00E-02

-1.50E-02

19

2.50E 02197301 197501 197701 197901 198101 198301 198501 198701 198901 199101 199301 199501 199701 199901 200101 200301 200501 200701 200901



6.00E-02

8.00E-02 1970s1970s 1980s1980s 1990s1990s 2000s2000s

2 00E 02

4.00E-02

0.00E+00

2.00E-02

-4.00E-02

-2.00E-02

-8.00E-02

-6.00E-02

301

401

501

601

701

801

901

001 01 201

301

401

501

601

701

801

901

001 01 201

301

401

501

601

701

801

901

001 01 201

301

401

501

601

701

801

901

20

1973

1974

1975

1976

1977

1978

1979

1980

1981

198 2

1983

1984

1985

1986

1987

1988

1989

1990

1991

199 2

1993

1994

1995

1996

1997

1998

1999

2000

2001

200 2

2003

2004

2005

2006

2007

2008

2009



70 0

Ex-ante & 5Y ex-post return - UK equity 1900 - 2003 -Quintiles ranked by Ex-ante return

61.8

50.0

60.0

70.0

32.437.9

30.0

40.0

4.6

0.0

10.0

20.0

-15.8-20.0

-10.0

0.0

21

4.1-5.8 5.9-6.4 6.4-6.8 6.8-7.6 7.5-13.8

Source: FactSet; BlackRock


0.45

Equity & Bonds: Conditional Distributions Equity & Bonds: Conditional Distributions -- 19951995

0.35

0.4

0 2

0.25

0.3

0.1

0.15

0.2

0

0.05

0.1

22

-30 -20 -10 0 10 20 30Source: FactSet; BlackRock


0 4

0.45


0.3

0.35

0.4

0.2

0.25

0.3

0.1

0.15

0

0.05

23



0.45


0.35

0.4

0.25

0.3

0 1

0.15

0.2

0

0.05

0.1

24



Long Run Average Earnings Yield Broken by Junk / Quality

Dec 1988 to Dec 2007

4 00%

2.00%

3.00%

4.00%

gs y

ield

in

the

mkt

) Historic Premium for Junk at ~3%

0.00%

1.00%

2.00%

of t

he M

edia

n Ea

rnin

g

-2.00%

-1.00%

0.00%

e Ea

rnin

gs Y

ield

(N

et o

-3.00%

2.00%

1 2 3 4 5 6 7 8 9 10

Act

ive

J k Q li

25Source: FactSet; BlackRock

Junk Quality

Lesson 6: Unconditional Risk Doesn’t Matter Much

Active Earnings Yield of the FTSE 350

Junk Deciles 1988-2009

20.00%

Ab l t J k (D il 10) N J k (D il 9)

15.00%

Absolute Junk (Decile 10) Near Junk (Decile 9)

Jan: Junk is extremely cheap

10.00%

Prem

ium

(FY

1/P)

0.00%

5.00%

Yiel

d

-5.00%

3/19

88

1/19

88

7/19

89

3/19

90

1/19

90

7/19

91

3/19

92

1/19

92

7/19

93

3/19

94

1/19

94

7/19

95

3/19

96

1/19

96

7/19

97

3/19

98

1/19

98

7/19

99

3/20

00

1/20

00

7/20

01

3/20

02

1/20

02

7/20

03

3/20

04

1/20

04

7/20

05

3/20

06

1/20

06

7/20

07

3/20

08

1/20

08

May: Junk is priced in historic range.

26

31/0

3

30/1

1

31/0

7

30/0

3

30/1

31/0

7

31/0

3

30/1

30/0

7

31/0

3

30/1

31/0

7

29/0

3

29/1

31/0

7

31/0

3

30/1

1

30/0

7

31/0

3

30/1

1

31/0

7

29/0

3

29/1

31/0

7

31/0

3

30/1

29/0

7

31/0

3

30/1

31/0

7

31/0

3

28/1

Lesson 6: Unconditional Risk Doesn’t Matter Much

Active Earnings Yield Broken down by Junk / Quality

January 2009

10.00%

12.00%

14.00%

yie

ld in

the

mkt

)

Jan: Extreme Junk is massively cheap

4.00%

6.00%

8.00%

of t

he M

edia

n Ea

rnin

gs

2 00%

0.00%

2.00%

ve E

arni

ngs

Yiel

d (N

et o

-4.00%

-2.00%

1 2 3 4 5 6 7 8 9 10

Acti

v

Jan 31-09 Long Run Average

Junk Quality

27

Junk Quality


6.00E-02

8.00E-02 1970s1970s 1980s1980s 1990s1990s 2000s2000s

2 00E 02

4.00E-02

0.00E+00

2.00E-02

-4.00E-02

-2.00E-02

-8.00E-02

-6.00E-02

301

401

501

601

701

801

901

001 01 201

301

401

501

601

701

801

901

001 01 201

301

401

501

601

701

801

901

001 01 201

301

401

501

601

701

801

901

28

1973

1974

1975

1976

1977

1978

1979

1980

1981

198 2

1983

1984

1985

1986

1987

1988

1989

1990

1991

199 2

1993

1994

1995

1996

1997

1998

1999

2000

2001

200 2

2003

2004

2005

2006

2007

2008

2009


For distribution to Professional Clients and should not be relied upon by any other persons.

The following notes should be read in conjunction with the attached document: 1. Issued by BlackRock Investment Management (UK) Limited, authorised and regulated by the Financial Services Authority. Registered

office: 33 King William Street, London, EC4R 9AS. Tel: 020 7743 3000. Registered in England No. 2020394. For your protection telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited.

2. Past performance is not a guide to future performance. The value of investments and the income from them can fall as well as rise 2. Past performance is not a guide to future performance. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time.

3. Mandates we manage may be exposed to finance sector companies, as a service provider or as counterparty for financial contracts. In recent months, liquidity in the financial markets has become severely restricted, causing a number of firms to withdrawn from the market, or in some extreme cases becoming insolvent This may have an adverse affect on the mandates we manageextreme cases, becoming insolvent. This may have an adverse affect on the mandates we manage.

4. Any research in this document has been procured and may have been acted on by BlackRock for its own purpose. The results of such research are being made available only incidentally. The views expressed do not constitute investment or any other advice and are subject to change. They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy.

5 This document is for information purposes only and does not constitute an offer or invitation to anyone to invest in any BlackRock 5. This document is for information purposes only and does not constitute an offer or invitation to anyone to invest in any BlackRock funds and has not been prepared in connection with any such offer.

6. This material is for distribution to Professional Clients (as defined by the FSA Rules) and should not be relied upon by any other persons.

7. Subject to the express requirements of any client-specific investment management agreement or provisions relating to the f f d ill id i f h l li i bj i management of a fund, we will not provide notice of any changes to our personnel, structure, policies, process, objectives or,

without limitation, any other matter contained in this document.

8. Unless otherwise specified, all information contained in this document is current as at {10th June 2009].

30

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