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Watson Wyatt identifies main risks to asset returns

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Watson Wyatt has identified and ranked 15 extreme risks that would have a high impact on global economic growth and asset returns if they occurred. 

 

In a paper entitled Extreme Risks, the firm ranks depression, hyperinflation and excessive leverage as its top three.

The bottom three are the end of fiat money, a major global conflict and a killer pandemic.

Tim Hodgson, senior investment consultant, says: “The events of the last two years have demonstrated that risk management cannot afford to stop at the 95th percentile and that we need to find ways of factoring in very unlikely, but high impact events. Being aware of risk in the extremes before they happen can protect value if built into a plan of action that can be implemented as soon as the need arises.”

In the paper the firm recommends that a robust defence against extreme risks can be built by combining a qualitative understanding, quantitative modelling and a cost-benefit analysis of possible strategies. 

According to Watson Wyatt, a qualitative understanding can be developed by institutional investors asking themselves what could cause certain events, whether they are plausible and what the consequences could be. Then it advises them to consider the investment risks and the impact on asset returns and, in some cases, liabilities.

Hodgson says: “By accounting for these risks in advance, rescue plans can be formulated so that they are ready to implement as soon as necessary to prevent value destruction. However, this approach does not come naturally as it goes against the status quo of reacting to events as they occur.”

The firm groups these risks into one of three areas: financial, economic, and political and other. Financial extreme risks revolve around solvency and whether a financial institution is able to pay its debts with available cash. The paper describes the interconnected nature of the modern financial system and that high levels of leverage mean insolvency for one institution can quickly become a systemic problem. It suggests the primary triggers for financial risks are falling asset prices and falling incomes or they can be generated by a recession in the real economy and transmitted to the financial sector through a default on loans. The extreme risks included in this category are excessive leverage, banking crises and insurance crises.

Economic extreme risks are less homogenous than the financial risks and range from a deflationary depression to hyperinflation and a return to a gold standard. The deflationary depression risk implies that government actions will prove incapable of returning the economy to sustainable growth, while the other economic risks essentially assume that government actions are successful, but at a price. The other economic extreme risks are currency crisis, sovereign default and the end of fiat money.

The third category of extreme risks derives from politics but includes climate change and killer pandemics. Other extreme risks included in this category are the end of capitalism, political crisis, disunity in Europe, major war and protectionism.

The firm says not all of these extreme risks are hedgable and that any hedge used is likely to be very imprecise. It cites the example of the outcome of a killer pandemic being highly uncertain and therefore its impact on assets and liabilities unknowable. However, it suggests that it will be useful to be in a position to decide how effective the hedge is required to be based on how much loss is acceptable. It concludes that the more loss that is acceptable the easier it is to hedge smaller proportions of the portfolio.

Hodgson adds: “More complete hedging increases complexity and is almost certain to require the use of derivatives, so thought needs to be given to whether the counterparty would be willing and able to pay out should that extreme event happen. In addition, the carrying cost of such a hedge is likely to be higher the more complex it is. On the positive side, derivatives provide much greater flexibility and the more precise targeting of risks. They also don’t require much capital therefore leaving the bulk of the portfolio untouched.”

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