Risk, Return, and Reality Revisited

This article originally appeared in the November 2008 HS Dent Forecast Newsletter. In the year and a half that has passed, the key insights remain: this recession is fundamentally different from all others of the post-WWII era.

On Friday, October 24, 2008, the Financial Times reported that swap spreads turned negative. It would be easy to dismiss this headline as just another bit of media noise except for one little technicality: according to all of the rules of finance, it is a mathematical impossibility. A negative swap spread means that the Treasury yield is higher than that of a swap of a similar maturity. As the “risk free” rate in virtually all financial models, the Treasury should always give the lowest taxable yield without exception. The pricing in the swaps market implies that the private issuers of swaps are somehow less risky than the U.S. government! Of course, this is absurd. All doubts about the fiscal responsibility of the government aside, no private company can ever be less risky than the U.S. government. With unlimited ability to tax and, if need be, print the needed money, a sovereign government by definition cannot default on debts denominated in its own currency.

Meanwhile, across the Atlantic, we found another absurd anomaly. Volkswagen briefly became the most valuable company in the world! A rush of panicked short covering caused the stock to triple in one day before finally easing to lower, albeit still grossly overvalued, price. Short sellers of Volkswagen found themselves wiped out…in the middle of an economic contraction that has decimated the auto industry.

Nassim Nicholas Taleb must be proud: “Black Swan” has become a standard expression in the American financial vocabulary, and his 2007 book by that name could not have been timelier. In Taleb’s context, a Black Swan is a high-impact, low-probability event beyond the realm of normal expectations, something along the lines of a tornado or earthquake in the natural world. Such natural disasters are highly destructive when they hit, but they are infrequent enough to make living in high-risk places such as Oklahoma or California possible and, in a financial context, affordable to insure. The problem, as Taleb repeats throughout his writings, is that in financial markets, “low-probability” events are a lot more common than our standard models allow.

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