PIMCO on Participants, Pricing and Risk Management

Vineer Bhansali at Pimco has a good post on current investment environment "The Three, Four, Five...P's of Pricing and Risk Management Revisited". He hits the nail!

Of course, the key reason is:

Events of last year have forced us to add to this plethora of P’s another one that modelers have largely ignored but cannot any longer: participants, both “Public” (the government) and Private. The purpose of this note is to explore pricing and risk management of portfolios in an environment where public participants are having an increasingly potent impact on valuations and market functioning. The string of recent announcements of various public sector initiatives renders this exercise far from simply academic.

And the conclusion for a lazy reader:

What can one do to manage the valuation and risks of portfolios in this environment of greater public sector involvement in a range of markets? First and foremost, absolute valuation of securities should take precedence over relative valuation, because there is considerable uncertainty as to which security can be targeted for a new paradigm price. Second, security prices are likely to reflect, even more than they have before today, the macroeconomic conditions that are likely to prevail. The relevance of economic intuition in pricing models becomes even more important. Third, diversification based on traditional measures of risk and return and co-movement relationships can break down as a new common factor becomes critical in determining outcomes. Much of this has already been documented even prior to the height of the current crisis. Identifying the key factors that will be relevant for risk management should take precedence over forecasting returns, volatilities and correlations. Finally, in a world where public and private preferences, which have different horizons of measurement, come into conflict, markets should be expected to be more turbulent, and the concept of in-built “tail risk” hedges is critical, since we should expect to see more frequent “jumps” as illustrated in Chart 1.

Of course this story will evolve over the next few years. I hope to have convinced the reader that the phenomenon of increasing influence from potent participants requires an approach where portfolios are constructed from first principles, and ranked according to their robustness to players’ actions. In a world where historical normal period experience, even with decades of data, has little relevance to valuation, it should be no surprise to risk managers that risk management statistics and concepts are also candidates for challenge. While there is no one cure-all, fortunately the push toward simplicity in investment portfolios that the new environment requires should be a welcome development.

Well said!