COMMERCIAL AND INDUSTRIAL MATHEMATICS

October 25, 2014

Seminar Series on Quantitative Finance - April 30, 2003

Abstracts

Tom Wilson, Oliver Wyman & Company
Valuing Financial Institutions: Integrating Internal and External Metrics
This talk focuses on the challenges of linking the metrics typically used by financial institutions to measure performance (e.g. RAROC, economic capital, etc.) and the metrics by which the firms are valued in the market (e.g. P/E, P/B multiples). Providing a clear link between these metrics is important for ensuring that the way that performance is evaluated internally is in alignment with the way that markets value the firm. Using a combination of empirical evidence and theory, we investigate the role of economic capital, returns, cost of capital, earnings volatility and growth on firm valuation.

Focusing especially on the appropriate cost of capital for financial services, we argue that many financial institutions significantly and systematically overvalue their investment banking and other higher systematic risk businesses and undervalue their retail banking, personal lines insurance and other low risk businesses. As a direct consequence, many institutions are defining and implementing corporate strategies that destroy shareholder value by unknowingly subsidising higher risk with lower risk activities. Recent theoretical research and empirical results indicate that this issue has substantial implications in terms of corporate strategy. In the article to be discussed, we take the theory to its logical conclusion and use cross-section and time series data to answer three important questions:

First, is there empirical evidence that shareholders require different hurdle rates for different businesses, even if each business is capitalised to a common rating standard? We will call this the 'Differentiated Cost of Capital Effect'. This effect has strong implications for evaluating the relative performance of individual business lines that reside under a common corporate rating umbrella.
Second, is there empirical evidence that, all else being equal, shareholders require a premium from firms that have increased leverage, and therefore probability of default, for a comparable risk/return? We call this the 'Leverage or Default Effect'. This effect has strong implications for corporate capitalisation and the rationalisation of the shareholder- and debtholder perspectives.
Third, is there empirical evidence that, all else being equal, shareholders place a premium on firms that have less idiosyncratic risk and can therefore afford greater leverage? We call this the 'Idiosyncratic Risk Cost'. This effect has potentially strong implications on corporate strategy and portfolio diversification.

David R. Koenig, Chair, PRMIA Board of Directors
Multiple Points of Failure: A New View on Risk Management
We discuss the notion of risk management as a managerial science and its incorporation into the business decision-making process. Brittle systems break badly. In other words, when they fail the consequences can be catastrophic. While the tail is comprised of catastrophic events, risk managers are charged with both determining sufficient capital levels to survive highly unlikely events and helping businesses to maximize the return on desired risk. Focus on using risk management to create ductile systems, ones that fail well, addresses both of these issues. In many cases, these systems lower the need for risk capital and also reduce the frequency of high-impact events. Building on lessons from network security experts and other concepts of risk management, risk managers can do more of a job to educate and disseminate information than most realize. Quantitative rigor is enhanced through qualitative implementation. If risk management is to avoid the fate of accountancy, it must become an integral part of a process rather than simply a function delivering reports.

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