Hazardous Forecasts and Crisis Scenario Generator

By Arnaud Clément-Grandcourt and Hervé Fraysse

This book presents a crisis scenario generator with black swans, black butterflies and worst case scenarios. It is the most useful scenario generator that can be used to manage assets in a crisis-prone period, offering more reliable values for Value at Risk (VaR), Conditional Value at Risk (CVaR) and Tail Value at Risk (TVaR).

Hazardous Forecasts and Crisis Scenario Generator questions how to manage assets when crisis probability increases, enabling you to adopt a process for using generators in order to be well prepared for handling crises.

• Evaluates risk-oriented philosophy, forecast risk-oriented philosophy and its processes
• Features scenario-building processes, with an emphasis on main and extreme scenarios
• Discusses asset management processes using a generator methodology to avoid risk understatement and increase optimization.

• Language: English
• Publisher: Elsevier Science
• Release date: Oct 6, 2015
• ISBN: 9780081007778

Book preview

Hazardous Forecasts and Crisis Scenario Generator

Arnaud Clément-Grandcourt

Hervé Fraysse

Table of Contents

Cover image

Title page

Copyright

Introduction

1: Risk-oriented Philosophy, Forecast-based Philosophy and Process

Abstract

1.1 A risk-oriented philosophy and a forecast-based philosophy

1.2 Rational expectations theory and the efficient market hypothesis

1.3 Irrational crisis behaviors make previous expectation hypotheses dangerous

1.4 How large is the rational hypothesis validity field?

1.5 Conclusion

2: Scenario Building Processes

Abstract

2.1 Most asset managers have only one or two scenarios in mind

2.2 Long-term scenarios and geopolitical surprises

2.3 Five-year scenarios

2.4 An efficient five-year scenario generator

2.5 Details on several scenarios

2.6 An efficient one-year scenario generator

3: How to Use These Scenarios for Asset Management?

Abstract

3.1 Philosophy of equity portfolio optimization

3.2 Which classic optimization processes are well fitted?

3.3 Risk aversion and utility function

3.4 Better fit processes for a crisis

3.5 Crisis process for equity portfolio optimization

3.6 Resilient bond portfolio building

3.7 Application

3.8 Conclusion

Conclusion

Appendix

A.1 Appendix

A.2 Growth rates

Bibliography

Abbreviations

Index

Copyright

First published 2015 in Great Britain and the United States by ISTE Press Ltd and Elsevier Ltd

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Notices

Knowledge and best practice in this field are constantly changing. As new research and experience broaden our understanding, changes in research methods, professional practices, or medical treatment may become necessary.

Practitioners and researchers must always rely on their own experience and knowledge in evaluating and using any information, methods, compounds, or experiments described herein. In using such information or methods they should be mindful of their own safety and the safety of others, including parties for whom they have a professional responsibility.

To the fullest extent of the law, neither the Publisher nor the authors, contributors, or editors, assume any liability for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions, or ideas contained in the material herein.

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© ISTE Press Ltd 2015

The rights of Arnaud Clément-Grandcourt and Hervé Fraysse to be identified as the authors of this work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988.

British Library Cataloguing-in-Publication Data

A CIP record for this book is available from the British Library

Library of Congress Cataloging in Publication Data

A catalog record for this book is available from the Library of Congress

ISBN 978-1-78548-028-7

Printed and bound in the UK and US

Introduction

In order to introduce the aim of this book, it is essential to highlight risk trends.

The second half of the 20th Century was characterized by a trend of a decline in major risks. Indeed, the end of the Cold War implied an unforeseen geopolitical risk setback. Moreover, cyclical economic moderation changes after big oil price changes, as well as sociopolitical crisis risk moderating, notwithstanding neoliberalism being observed. It is now obvious that this declining trend is over and that these trends have reversed.

Geopolitical risks are rising trends in Europe, Asia and the Middle East; the great recession showed how risks are rising in a financial and economic world that is increasingly complex and connected. Economic cycle theories, such as Kondratieff’s long wave theory, faced new problems (China and Russia entering in the capitalist system, deregulation and central banking’s new philosophy). Sociopolitical risks are increasing whilst lagging economic indicators are recovering. So, it is no longer valid to calculate measures on risk which disregard upward trends. Disregarding these trends in decision methodology, asset management and portfolio building implies big disappointments in the next crisis. A portfolio optimization based on utility function simply using variance (as the only measure of risk in the modern portfolio theory (MPT)) no longer seems logical nor prudent.

The aim of this book is to show that with 21st Century risk trends, an economic scenario generator including crisis scenarios is essential for avoiding risk undervaluation. Economic scenario generators (ESGs) have been used for years by insurance company asset liability management; now, there are compelling reasons to use economic scenario generators (ESG) with crisis scenarios for many kinds of asset management. The aim of this book is to convince readers that crisis scenario generators could be necessary.

In order to be able to cope with the new challenges of the 21st Century, it is necessary to learn lessons from the past. That is why in order to avoid depression scenarios and the multiple-crisis scenarios of the 1930s, budgetary reflation policies as well as overabundant money creation have been necessary. The Great Recession, indeed, was not a great depression because central banks were surprisingly quick and smart in their innovative monetary policies and truly bold in their actions. Indeed, to multiply a monetary base by two or three is audacious because the success of these actions was absolutely unsure: in retrospect, it seems clear that it was the right decision. Governments were also bold in their budgetary policies that followed in spite of the steady debt increase necessary to finance these strong reflationary actions.

Big base money creation such as this implies an unstable context which has two important implications for asset managers and investors who want to take into account these new settings.

Firstly, they have to define probabilities for a wide range of scenarios (geopolitical experts could be very helpful for this), including best and worst case scenarios. Failure probability in order to avoid another depression in case of a multiple-crisis process over a short period of time is important. Many scenarios can be built on this theme. Moreover, the comparison between the 1930 crisis and the current context suggests that among all the monetary problems discovered during the 1930s, the competition between the US dollar, Chinese yuan and the Euro could be more dangerous in the future than the replacement of the pound sterling with the dollar as the reserve currency. Nevertheless, the worst is never sure and some best-case scenarios can be built on positive action by the G20 (the group of the twenty most powerful heads of state or heads of government that could slowly become a ruling world group) to avoid protectionism, trade war, competitive devaluations and currency instability linked to reserve currency problem. The G20 seems to be the only hope in avoiding this major instability risk that could amplify trade war and protectionism risks.

Secondly, to take into account the next crisis risk and a multiple-crisis process risks, measurement risk processes have to be based on an (or even several) economic scenario generator which gives precise risk measurements. The huge creation of base money induces instability, which increases the probability of a future crisis. The bigger the debt-to-gross national product (GNP) ratio is, the bigger the danger of an important financial and economic crisis. Furthermore, when there are really low interest rates (near zero), it would be very difficult to cure a potential crisis or reduce its size since interest rates could not be decreased even further.

Therefore, Chapter 1 will deal with risk-oriented philosophy, forecast risk-oriented philosophy and processes. Chapter 2 is devoted to scenario building processes, especially those to be used in generators with an emphasis on major scenarios and extreme scenarios. Chapter 3 discusses asset management processes using generator methodologies in order to avoid risk understatement and for optimization; how can assets be managed when crisis probability increases? To settle a crisis process adapted to the current economic period, it seems appropriate to elaborate an investment approach centered around the use of an Economic Scenario Generator (ESG).

1

Risk-oriented Philosophy, Forecast-based Philosophy and Process

Abstract

Philosophy is essential for staying rational in a period when there are so many risks, so many risk measures and so many processes to calculate them such that a logical endeavor has to be made systematically in order to consider all the possibilities. A philosophy for an unsteady and unreliable world is needed to stay rational in the face of geopolitical challenges inducing sociopolitical risks, climate challenges and financial uncertainty. Several elements can be mentioned to illustrate our proposition.

Keywords

Capital asset pricing model (CAPM)

Economic Co-Operation and Economic Development (OECD)

Economic Cycle Research Institute (ECRI)

Federal Reserve System (FED)

Imperfect knowledge economics (IKE)

Irrational crisis behaviors

Lehman bankruptcy

Mimesis

Rational expectations hypothesis

Tail value-at-risk (TVaR)

1.1 A risk-oriented philosophy and a forecast-based philosophy

1.1.1 Why a risk-oriented philosophy?

Philosophy is essential for staying rational in a period when there are so many risks, so many risk measures and so many processes to calculate them such that a logical endeavor has to be made systematically in order to consider all the possibilities. A philosophy for an unsteady and unreliable world is needed to stay rational in the face of geopolitical challenges inducing sociopolitical risks, climate challenges and financial uncertainty. Several elements can be mentioned to illustrate our proposition.

It is obvious to note that, nowadays, economic stability is less secure than it was in the second half of the 20th Century: indeed, in 1989, geopolitical risk diminished in an unforeseeable manner when Reagan, President of the United States of America, with global power, began to deregulate by proposing a North American accord, the so-called NAFTA, creating a common market between the United States, Canada and Mexico. This decision taken in a globalized world, in which transmission capabilities allowed an online financial integration, had a significant impact on risk and economic stability. In the 21st Century, this new world appears to be unsteady with an unproven reliability; weaknesses appeared with crises that became more frequent and more systemic than previously. Therefore, to stay rational, a philosophy is needed.

A global financial integration, including many developing and emerging economies with recent financial experience with unproven learning capability, implies a global risk supervision that is not available with the current International Monetary Fund (IMF) or other international organizations. The IMF missions and means have to be enlarged, especially with learning lessons for less-skilled countries; its credibility will be increased when important emerging countries are more present and active in this international organization. Up to now, financial governance has been insufficient compared to world financial integration. A last resort of international lending is needed. Risk-oriented philosophy would evolve if these reforms were well made.

Another source of instability is concerned with the status of the US dollar. Indeed, the reserve currency status of this money could be challenged in the years to come because it is criticized for its weaknesses resulting from big money creation and the US trade balance deficit; however, this deficit adds to the dollar’s international monetary base which has to be increased regularly to avoid recessions. Is this monetary base well adapted for world growth? This is an example of a problem without any easy solution. A currency war as seen in the 1930s would lead to a very dangerous risk of financial and banking crises. A risk-oriented philosophy is essential for staying rational in a currency war.

1.1.2 Management by crisis is the philosophy of global capitalism

A crisis entails necessary government action and some urgent reforms; after the end of the crisis, reforms are less urgent. This applies to every capitalist country and possibly to less democratic countries that use capitalism as a recipe for growth.

The world integration implies reforms. An initial step was the G20’s first meeting in 2009 in the middle of the Great Recession, but this was not enough. To make globalization more reliable with a financial integration which is essential to reduce crisis probability, the G20 has to set up the necessary reforms. For that, the G20’s legitimacy power, particularly on the regulatory side, has to grow significantly. Taking into account all the financial crisis propagation scenarios and their mean reversing possibilities with good and bad consequences requires a philosophy of capitalism. To stay more rational than competitors, it is essential to study many kinds of possible crisis in order to not be surprised; the best asset management returns can be obtained by this philosophy; contrarian asset managers (assessing higher probabilities than the market to turnaround and the mean reversing process) are able to sell very early when crisis probability increases and to buy early when the mean reversing process probability increases. Usually, these contrarians are very experienced asset managers, often located in Boston or Edinburgh.

1.1.3 A forecast-based philosophy and risk evaluation processes

In a crisis-prone period in which there are so many reciprocal action propagations for solving problems, philosophy is essential for staying rational. Many forecasts, in this kind of period, are based on imperfect measures. Many forecasts are needed; however, there are so many hazardous methods for forecasting figures, trends, reversals and so many imperfect measures that some logical rules are necessary. Crisis processes caused by increasing fragilities are so difficult to forecast that an endeavor to improve methods is necessary to make a forecast process suitable for forecasting a crisis period; a methodological thought based on an economic philosophy is necessary. The French Conseil d’Analyse Economique (French council of economic analysis) in a financial crisis report [BOY 04] emphasized a new concept for monitoring a crisis: the financial accelerator. As firms are further leveraged, financed mostly by credit, an increased profitability has a strong effect on firm value and investment capability; this effect (and its opposite) increases the size of the cycle; there is also the pro-cyclical effect of the credit multiplier. These instability factors and their correlations have to be monitored, but imperfect and asymmetric information is spread by oligopolistic channels; therefore, risk is taken by economic agents, especially firms in a pro-cyclical manner that increase crisis risk. Herd effects, bubbles induced by excessive liquidity with