More on the Swiss Franc move

The always excellent Matt Levine has reported in Bloomberg (with respect to the recent removal of the cap on the price of the Swiss Franc) that:

Goldman Sachs Chief Financial Officer Harvey Schwartz said on this morning’s earnings call that this was something like a 20-standard-deviation event

While mathematically this might be true, the question is if it makes sense at all. Since it is mathematically easy to model, traders look at volatility of an instrument in terms of its standard deviation. However, standard deviation is a good descriptor of a distribution only if the distribution looks something like a normal distribution. For all other distributions, it is essentially meaningless.

The more important point here is that the movement of the Swiss Franc (CHF) against the Euro had been artificially suppressed in the last three odd years. So from that perspective, whatever Standard Deviation would have been used in order to make the calculation was artificially low and essentially meaningless.

Instead, the way banks ought to have modelled it was in terms of modelling where EUR/CHF would end up in case the cap on the CHF was actually lifted (looking at capital and current flows between Switzerland and the Euro Area, this wouldn’t be hard to model), and then model the probability with which the Swiss National Bank would lift the cap on the Franc, and use the combination of the two to assess the risk in the CHF position. This way the embedded risk of the cap lifting, which was borne out on Thursday, could have been monitored and controlled, and possibly hedged.

There are a couple of other interesting stories connected to the lifting of the cap on the value of the CHF. The first has to do with Alpari, a UK-based FX trading house. The firm has had to declare insolvency following losses from Thursday. And as the company was going insolvent, they put out some interesting quotes. As the Guardian reports:

In the immediate aftermath of Thursday’s move by the Swiss central bank, analysts at Alpari had described the decision as “idiotic” and by Friday the firm had announced it was insolvent. “The recent move on the Swiss franc caused by the Swiss National Bank’s unexpected policy reversal of capping the Swiss franc against the euro has resulted in exceptional volatility and extreme lack of liquidity,” said Alpari.

The second story has to do with homeowners in Hungary and Poland who borrowed their home loans in Swiss Franc, and are now faced with significantly higher payments. I have little sympathy for these homeowners and less sympathy for the bankers who sold them the loans denominated in a foreign currency. I mean, who borrows in a foreign currency to buy a house? I don’t even …

There is a story related to that which is interesting, though. Though Hungary is more exposed to these loans than Poland, it is the Polish banks which are likely to suffer more from the appreciation in the CHF. The irony is that the Hungarian market was initially much more loosely regulated compared to the Polish market, where only wealthier people were allowed to borrow in CHF. But in Hungary, the regulator took more liberties in terms of forcing banks to take the hit on the exchange rate movement, and the loans were swapped back into the local currency a while back.

In related reading, check out this post by my Takshashila colleague Anantha Nageswaran on the crisis. I agree with most of it.

 

Why Brazil is undervalued by punters

When India exited the 2007 Cricket World Cup, broadcasters, advertisers and sponsors faced huge losses. They had made the calculations for the tournament based on the assumption that India would qualify for the second group stage, at least, and when India failed to do so, it possibly led to massive losses for these parties.

Back then I had written this blog post where I had explained that one way they could have hedged their exposure to the World Cup would have been by betting against India’s performance. Placing a bet that India would not get out of their World Cup group would have, I had argued, helped mitigate the potential losses coming out of India’s early exist. It is not known if any of them actually hedged their World Cup bets in the betting market.

Looking at the odds in the ongoing Football World Cup, though, it seems like bets are being hedged. The equivalent in the World Cup is Brazil, the home team. While the world football market is reasonably diversified with a large number of teams having a reasonable fan following, the overall financial success of the World Cup depends on Brazil’s performance. An early exit by Brazil (as almost happened on Saturday) can lead to significant financial losses for investors in the tournament, and thus they would like to hedge these bets.

The World Cup simulator is a very interesting website which simulates the remaining games of the World Cup based on a chosen set of parameters (you can choose a linear combination of Elo rating, FIFA ranking, ESPN Soccer Power Index, Home advantage, Players’ Age, Transfer values, etc.). This is achieved by means of a Monte Carlo simulation.

I was looking at this system’s predictions for the Brazil-Colombia quarter final, and comparing that with odds on Betfair (perhaps the most liquid betting site). Based purely on Elo rating, Brazil has a 77% chance of progress. Adding home advantage increases the probability to 80%. The ESPN SPI is not so charitable to Brazil, though – it gives Brazil a 65% chance of progress, which increases to 71% when home advantage is factored in.

Assuming that home advantage is something that cannot be ignored (though the extent of it is questionable for games played at non-traditional venues such as Fortaleza or Manaus), we will take the with home advantage numbers – that gives a 70-80% chance of Brazil getting past Colombia.

So what does Betfair say? As things stand now, a Brazil win is trading at 1.85, which translates to a 54% chance of a Brazil victory.  A draw is trading at 3.8, which translates to a 26% chance. Assuming that teams are equally matched in case of a penalty shootout, this gives Brazil a 67% chance of qualification – which is below the range that is expected based on the SPI and Elo ratings. This discount, I hypothesize, is due to the commercial interest in Brazil’s World Cup performance.

Given that a large number of entities stand to gain from Brazil’s continued progress in the World Cup, they would want to protect their interest by hedging their bets – or by betting against Brazil. While there might be some commercial interest in betting against Colombia (by the Colombian World Cup broadcaster, perhaps?) this interest would be lower than that of the Brazil interest. As a result, the volume of “hedges” by entities with an exposure to Brazil is likely to pull down the “price” of a Brazil win – in other words, it will lead to undervaluation (in the betting market) of the probability that Brazil will win.

So how can you bet on it? There is no easy answer – since the force is acting only one way, there is no real arbitrage opportunity (all betting exchanges are likely to have same prices). The only “trade” here is to go long Brazil – since the “real probability” or progress is probably higher than what is implied by the betting markets. But then you need to know that this is a directional bet contingent upon Brazil’s victory, and need to be careful!

Pricing railway safety

Yet another railway accident has happened. As someone on twitter pointed out,

The problem with the Indian Railways is that there is no real measure of safety. How do we know how much safer the trains and tracks are compared to last year? Given the way the Railway finances are put out currently, there is no way to figure this out. Without the railways putting out more disclosures, is there a way to put a number on how safe the Indian Railways are? In other words, is there a way to “price” railway safety?

As you are well aware, and as the above tweet points out, it is standard practice in Indian Railway accidents for the Railway Minister to announce an ex-gratia payment to the families of the dead and the injured in case of any accident. I’m not sure if there is a formula to this but one cannot rule out the arbitrariness of this amount. As I had pointed out in an earlier post on RQ, accident compensation needs to be predictable and automatic. Can we use this to price railway safety?

First of all, we need to point out that the railways follows a cash accounting system, and thus doesn’t need to account for any contingent liabilities such as ex-gratia payment (last weekend I sat through an awesome lecture by Prof. Mukul Asher (councillor to Takshashila) on public finances, and he pointed this out). Hence, it would be prudent on behalf of the Indian Railways to hedge out this contingent liability.

How do you hedge a contingent liability? By buying insurance! What the Indian Railways needs to do is to buy group accident insurance – all the ex-gratia payments will then by paid out by the insurance company, and the railways will only pay a premium to these companies, thus hedging out the risk! And this process will help put a price on railway safety!

How is that? Let us say that given the railways’ bad record in safety, and its continued promises that safety will be improved each year, the railways decides to take up group accident insurance on an annual basis. Let us say that there is a competitive bidding process among general insurers in India (both public and private sector) to provide this insurance (railways is a large organization, and insuring them will be a matter of prestige, so companies will bid for it). The premium as determined by this competitive bidding process is the price of railway safety!

We can do better – instead of buying one overall policy, the Railways can think of insuring different routes separately, or perhaps zones. This will help put a price on the safety of each route or zone! There will be some transaction cost, of course, but price discovery will happen, and we will be able to put a price on risk!

But then, this is all wishful thinking. It is unlikely this will happen because:

1. Given the cash accounting system followed by the railways, there is no incentive to hedge contingent liabilities
2. Buying insurance means increasing scrutiny. The railways will not want to be scrutinized too hard. It is currently an opaque organization and it will want to be that way.
3. Given the railways are wholly government owned and there are government owned general insurers, there might be some collusion which might  result in underpricing the risk.
And so forth…

Nevertheless, the point of this post is that it is possible to put a price on safety!