Risk Reward Newsletter 2006 Quarter 3
In this Newsletter you will find
Risk Management Case of the Quarter – Amaranth
Undoubtedly the most important case this quarter is the collapse of Amaranth, a hedge fund. In a scenario reminiscent of the failure of Long Term Capital Management, Amaranth Advisers managed to lose USD 6.4bn of investors’ funds.
What are the key lessons and what went wrong? At the heart of the problem is that hedge funds tend to operate technical models on which they base their trading activity and by doing so they are trying to seek out enhanced returns for their investors. These investors should recognise that enhanced returns must always come at a price, which is an enhanced risk of loss. However they may easily take the view that whilst they can only lose 100% of their investment, they do have the opportunity of winning returns in excess of 1000% if things go really well.
Remember that most hedge funds are not regulated and that most models make simplifying assumptions to enable solutions to be identified and taken advantage of in the market.
Typical assumptions made in such trading environments may include the following:
- That all markets are equally and infinitely liquid
- That every transaction would find an arms length intelligent counterparty
- That markets are rational and normal
- That external events can be ignored
- That counterparty credit risk can also be ignored
These simplifying assumptions enable complex mathematics to identify opportunities in the market for the hedge fund to exploit. Of course every time you implement a model based upon any form of assumption, if that assumption becomes invalid it impacts the accuracy of the model and the trading strategy adopted will be sub optimal.
In the case of Amaranth the list of groups investing client money included Goldman Sachs, Deutsche Bank, Man Group, Credit Suisse and Union Bancaire Privee.
Fauchier Partners manages USD 4.3bn in hedge fund investments and inherited a USD 30m position in Amaranth. In a letter to their investors they identified the shortcomings at Amaranth as being:
Apparent absence of sufficient risk controls
- High leverage
- Poor transparency
- Performance heavily dominated by one strategy
- Uncapped expenses in addition to management and performance fees
- Annual reset of high watermark on performance fees
- Self-administration, so no external party was verifying returns
- In-house broker dealer, making it possible to smooth returns
- Individual traders who were not investing in their own books
- Poor liquidity terms
As a result of this Fauchier disinvested from Amaranth in December 2005, foreseeing problems ahead.
At the heart of the issue is the level of due diligence that is conducted on hedge funds by financial institutions. Fauchier clearly believes that this was inadequate and that by implication other similar events will occur. Well Amaranth is the second big loss following LTCM, so another failure next year is probable. The problem purely is working out which fund would be the one to fail!
Source: The Times (London) 13 October 2006.
IAS 39 – Accounting for Financial Instruments
The development of international accounting standards is something that we generally welcome. It will enable accounts to be prepared globally on a set of consistent and well-understood accounting policies, facilitating global understanding of risk and performance.
Generally this is all well and good – and then there is IAS 39…
Accounting for derivatives has long been a subject of concern. Should they be on balance sheet or off balance sheet? Should the change in value go through profit or loss or be taken to equity?
IAS 39 has tried to address this, but in so doing has developed an arcane set of rules that are difficult to implement, could be abused and result in disclosures that are almost impossible to understand.
The basic idea underpinning the rules is that if a transaction has been entered into to hedge the equity of the company, then any resulting gain or loss should really go to equity. For most of the rest it should go the profit and loss and you need to have some rules to deal with changes between the two and the additional disclosure of the reason for the change.
There we have it – in one paragraph we have managed to come up with what would be a simple and easy to apply basic proposition which everything else becoming an example.
IAS 39 takes the opposite approach. By trying to cover everything and therefore moving away from common language usage, the standard becomes hard to understand and sometimes appears rather odd. Firstly you have to designate transactions as being fair value through profit or loss. Fair value is effectively either mark to market or mark to model although there is more guidance on this. This is a formal designation of intention.
Secondly hedges need to be formally designated as such, with documentation identified and the specific assets set out.
Amongst the hardest to use rules are those on risk and reward and control (in that order). If an institution has managed to transfer the majority of the risks and rewards of a financial asset to a third party, then the asset is derecognised. That means it becomes off balance sheet with an explanation of the remaining risks. Likewise if the majority of the control of the asset is transferred, even though it still has the risks and rewards, then again the asset is derecognised and disclosed. So what is material?
The market appears to be in two camps. One says that there is an 80-120 rule with the other taking the 90-110 approach. That means that identical firms in identical situations will actually treat identical assets differently. This is purely one of many concerns we have over this particular standard, which we would contrast to IAS 21 (foreign currency) which is both easy to understand and simple to implement.
As an accountant one does despair sometimes at the way that we make things increasingly difficult. Creating complicated rules that are difficult to implement and impossible to understand can hardly make any sense, so we hope that IAS 39 is reviewed and amended in the near future.
Business News from Risk Reward Limited
RiskReward Training
In this quarter we have further increased the size of our lecturing faculty, being able to welcome a wide range of additional lectures with a broad range of skills. Key amongst these are the following areas of specialist interest:
- Islamic finance
- Corporate finance
- Internal audit
- Credit risk
- Central banking
Again broad ranges of assignments have been undertaken on an international basis. Amongst these, the following training assignments have been successfully completed:
Operational risk (Hong Kong)
- Auditing derivatives (Middle East)
- Accounting for derivatives (IAS32 and IAS39) – Singapore
- Operational risk and corporate governance – UK
- Business process reengineering - Malta
The final quarter of 2006 will be our busiest quarter to date and we have already taken bookings throughout 2007 and into 2008. If you are likely to have any training requirements in the future, do contact us as soon as possible so that we can schedule the appropriate resources.
Property Investment Opportunity
The Fulbari Spa & Resort Hotel
This quarter we are focusing on one specific property for which we have an exclusive listing. The Fulbari Spa is the top hotel in Nepal and one of the Leading Hotels of the World. It is available exclusively through Risk Reward Limited at a price of only USD 50m – reflecting the uncertainty that there has recently been in Nepal.
We are pleased to announce that the situation in Nepal has stabilised and that tourists are returning to the area. As the top hotel near to Kathmandu, the Fulbari Spa will be able to take full advantage of this upturn. It is available for sale by the original owners with planning permission to further extend the hotel.
The Fulbari Spa currently has some 165 five star rooms, a spa and a 9 hole golf course all on the top of a Himalayan mountain – probably the most spectacular hotel in the world. It will not be available at this price for long, so we suggest that if you do have any interest that you contact us immediately.
Investment Opportunities
Capital Investment Opportunities
This quarter we are focussing on two transactions that we currently have available for funding, both based in the UK.
Auxetica Limited
Auxetica Limited is an innovative designer of polymeric stents. Stents are small tubes that are inserted into vessels within the human body to either create stability or clear some form of blockage. Typical uses include cardiovascular (heart) stenting and prostate stenting.
Current stenting products available on the market are basically variants on a form of metal structure (either coated to contain drugs or uncoated), which look a bit like a small piece of chicken wire. It has long been known that this is not an ideal platform for stenting and that problems do occur. Auxetica has designed a series of entirely polymeric stents to become the new platform for the industry.
Currently seeking funding of up to USD 10m, Auxetica is looking for any corporate or individual investors who wish to come on board as part of this funding round or requires additional information should contact them through Risk Reward Limited. Dennis Cox, CEO of Risk Reward Limited has taken a role as CEO of Auxetica Limited.
Legal Eagles
Conveyancing in the UK is a laborious process, subject to delay and frustration. For the individual purchaser the process is left in the hands of the solicitor undertaking the process, without there being any ability for the individual to know the actual stats of the work, who is causing any delay and why this is occurring.
Legal Eagles have designed a software solution for this to make the entire process transparent. It also will make conveyancing solicitors much more efficient and therefore potentially reduce the price of the entire process.
Currently seeking funding of up to GBP 1m, Legal Eagles is looking for any corporate or individual investors who wish to join this exciting venture or require additional information to contact Risk Reward Limited. Dennis Cox, CEO of Risk Reward Limited has also accepted the position of CEO of Legal Eagles.
For more information about RiskReward and its divisions please visit www.riskrewardlimited.com or telephone Lisette Mermod, Director of Business Development at +44 (0) 1277 218 843 or Mobile +44 (0) 7968 970 942.
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