Category Archives: dynamic risks

Song of the Martingale

John Kay at the Financial Times has a nice column reminding us of the delusions of following a martingale betting strategy. It’s a persistent delusion that shows up in many different contexts.

The uncertain future of natural gas

Today is the official release event for the MIT study on the Future of Natural Gas. It’s a wide ranging study examining the role of natural gas in meeting future energy demand under carbon dioxide emissions constraints, and recommending appropriate policies–both for the US government and for industry. I was a member of the study group producing the study. I’ll let the full length study speak for itself on the many different issues it addresses. I want to use this blog post to expand on one specific point which is the huge uncertainties we face in charting any path forward as manifested in the fluctuating price of natural gas.

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When a hedge becomes a risk: The recent rally in corn prices.

Commodities markets have been quite agitated in May. The tremors felt on May 5 have not dissipated and recent data on the US economy, the risks of inflation in China’s and the protracted debt crisis in the EU left many traders wary. Prices of precious metals, industrial metals and oil have all dropped. So far, grains, led by corn, have held their value pretty well.

Corn is now being planted to be harvested in August. Weather is the main factor affecting the progress of planting and yields (#bushels per acre), and consequently a key driver of prices for new corn. Estimates indicate that the planting season is behind schedule, and that flooding of the Mississippi has destroyed some fields. Lower expected yields and acreage put further strains on an already historically tight ratio of stocks-to-usage – a measure of supply and demand.

Presumably these facts should have a greater impact on the incoming crop season (new corn). Yet, the recent sharp rally in corn prices occurred in nearby contracts (July futures) rather than in December futures contracts. Why is old corn more bullish than new corn?

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More on Pensions & Risk Sharing

Yale’s Robert Shiller used his occasional Sunday New York Times column this week to dive deeper into the risk sharing issues at hand in the debate about public employee pensions. As I mentioned in a previous post, the idea of pensions as a risk sharing device is probably a fruitful line to pursue. Shiller hardly moves the ball, but the mere fact that someone of his stature and insight picked it up at all is encouraging.

En route, Shiller mentions a paper by Henning Bohn of UC Santa Barbara. Two things to note about that paper… First, it’s less about risk sharing and more about arbitraging financial frictions. I suppose the two are closely related, but they sure sounds distinct. Second, and more importantly, Bohn’s paper is about the right level of funding for pension plans, and in no way takes a stand on the right valuation of the existing liabilities. Bohn’s claim is something like this: one should underfund a $100 liability by putting aside only $60. But even if you give him this point, that isn’t the same thing as saying that at $60 the pension is fully funded. The liability is still $100, and Bohn’s paper doesn’t contest that. He’s just saying it’s ok to underfund. As mentioned in my earlier post, these are two distinct points.

Shiller ends the column with a plug for an idea he has been hawking for a while, GDP linked bonds. The idea sounds exactly right. But it hasn’t taken off–yet. Perhaps it will soon. Or perhaps the mechanics are just infinitely more difficult than it sounds like at first. Pensions and risk sharing and financial innovation are a hugely complex topic. The time scales are long and the actors involved encompass the whole body politic–born and yet to be born. Moreover, the issues to be settled are so vast that it is difficult to imagine any narrowly crafted contract — and all financial contracts are narrowly crafted, unlike a ‘social’ contract — could adequately express and delineate whatever consensus was achieved. This is where an attempt to address the problem from a purely technocratic, financial perspective, as Shiller’s proposed GDP bonds purport to do, is bound to miss the mark by a mile.

Politics & Pensions, Risk & Return

A new report by Dean Baker on “The Origins and Severity of the Public Pension Crisis” is getting a lot of attention. It’s hard not to notice that public employees’ pension benefits are under attack. Baker’s piece is a thoughtful look into the numbers and the economic forces behind the numbers, and they make a useful contribution to an informed approach to the issue. However, while he gets some things right, he gets one thing wrong, and it is useful to separate the wheat from the chaff.

Baker makes essentially three points about the shortfall between pension assets and liabilities. One is about looking back, to see how we got here. A second is about where we are now, assessing the true size of the current shortfall. The third is looking forward, to see what it will take to remedy the situation.

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How to Discount Public Pension Liabilities

Monday’s WSJ has a story about a move by the new House Republican leadership to put pressure on state and local public-employee pension authorities. Buried inside the political fights is an important valuation question: what is the right discount rate to use when valuing the liabilities of a public pension plan? The Government Accounting Standards Board has a project to review this issue.

Risk is a key element of many of the arguments. Proponents of the relatively high discount rates argue that (1) the right rate is determined by the return one can expect on the money invested to payoff the future liability, (2) a high rate of return can be reliably expected given a long time horizon, and (3) state and local governments have a long (endless?) life. Point #2 is a fallacy, but one that continues to have many adherents. This poor understanding of how risk compounds over time undermines many valuations. A number of articles by Paul Samuelson, Robert Merton or Zvi Bodie address this fallacy in various manifestations. A good one by Samuelson is here.

For another approach to critiquing the current practice, see the testimony of my colleague, John Minahan. Thanks also to John for suggesting this comprehensive introduction to the conflict between the historically received pension model and modern financial economics: a paper by Bader and Gold on “Reinventing Pension Actuarial Science.”

The Weak Tie Between Natural Gas and Oil Prices

The last two years has seen a dramatic decoupling of natural gas and oil prices. After prices for both commodities collapsed at year-end 2008, the price of oil recovered, but the price of natural gas has remained low. The ratio of the natural gas price to the oil price is at the lowest point in decades.

Ironically, this has happened just as a string of academic papers had firmly established that the two price series move together–for example, here, here and here. The International Energy Agency’s 2009 World Energy Outlook reprinted a table from one of these papers showing how an increase in the price of oil would be mirrored over the subsequent 12 months by a matching increase in the price of natural gas.

My colleague, David Ramberg, and I have just released a study attempting to make sense of these apparently contradictory facts. The bottom line: while a tie between the two series can be firmly established in a statistical sense, two features of this relationship have not gotten enough emphasis. First, there is an enormous amount of extra volatility in natural gas prices, so over short horizons like one or two years, the statistical tie between the two price series is very often swamped by extra swings in the natural gas price. Second, the level of the tie between the two prices — the normal ratio — is unstable over time, so that at longer horizons it is difficult to pin down the expected relationship.

Risks Are Not Constant Through Time: Capacity Factor Risk at Nuclear Power Plants

My colleague, Yangbo Du, and I have just released a study of the dynamic structure of capacity factor risk through the life-cycle of a nuclear power plant. This is based on the performance of reactors in countries all around the world, using the International Atomic Energy Agency’s database. Here is the profile of the variance in the capacity factor through the life of the reactor:

The risk is greatest when the reactor is just starting up. It then declines dramatically. Over time, however, due to the small, but cumulating possibility of a permanent shutdown it rises again.

This is a nice demonstration of the fact that risks are not typically constant through time. The constant compounding of risk is a key assumption behind the usual discounting rule, but many people forget about this and just apply the rule to any and all problems, even when risks evolve in more complicated ways.

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