Article: Lessons from Time Travel and the New Year's Resolutions in Finance and Risk27 December 2015 | Diana Higgins
Some of us enjoy working making decisions today, based on evolving events and uncertain views of the future. Other professionals feel more comfortable with the certainty of the past to understand a clear picture of the present. While observing the personalities of some of my colleagues in different teams I have reflected on which tasks belong to finance, which ones belong to risk, and helps me deal with those that cross each other’s border lines. While writing this article, I thought of those that in the New Year are tasked to improve the middle and backoffice operations, and make the most of the skills of each team member.
Who is responsible for the “cost of credit” report? The metric is not far from being an estimation of the Credit Value Adjustment (CVA) with certain rules mandated by the International Accounting Standards (IAS). Which team should routinely produce margin calls? These are letters very similar to invoices that request or agree on payments of collateral to or from an exchange or a counterparty. The CVA and collateral calculations are based on risk metrics. However, the monthly reporting of cost of credit is a routine similar to the accountants' monthly reporting of financial results. The generation of letters, instructing payments, recording bank balances due to margining are tasks similar to the recurrent invoicing, payment instructions, settlement and ledger bookings performed by back offices or treasury teams.
I take the liberty of referring to Stephen Hawking’s and Einstein’s thoughts about time travel. These genius’ minds think that it is possible to travel into the future once someone can beat or at least almost match the speed of light. Also, these scientists explain that a certain future cannot be predicted because conditions keep changing and new situations arise leading to new "initial conditions" that may drive the course of events in a different direction. On the other hand, travelling into the past means that you could prevent your parents from meeting each other, which may mean that you would not exist. If you do not exist then how come were you able to travel into the past and prevent them from meeting? By the way there is a fun way to learn some of these thoughts by watching the 1980’s classic “Back to the Future”. So far, these theories conclude that the past is certain and cannot be changed, and the present keeps changing as time goes on such that it is not possible to be certain about the future.
Back to Earth, we can think of Finance and the Back Office as being responsible for taking information from the past and using it in the present. For example, how much do we have to pay today on interest charges given the prevailing rates during the past month? Or how much product was sold and at what price? This information from the past is used to produce an invoice or to agree paying certain amount from or to the counterparty in the present. These data is certain and is used to generate the income statement as of the previous 31st of December. The profit or loss is a fact and cannot be changed because the revenues and costs ocurred in the past.
Well, I am of the view that all these tasks are mastered by finance, back office and sometimes treasury teams. They use information that is certain, or deterministic to instruct payments, or to produce a report for those who want to understand today what happened in the past.
The risk professional instead uses probability to estimate future sales, or costs. These professionals analyse historical data available today combined with potential future events to draw different scenarios of prices and volumes, and most likely values of profits or losses to be made in the future. Credit risk checks the financial health of a company to estimate how long could it take for such company to default in the future, what circumstances may drive a company to collapse and how likely are these events to happen.
The risk professional uses today’s information to produce different scenarios and to make decisions by choosing those that in the company believes are the most likely situations. Based on these views, the company makes decisions and continues to change those decisions as new information is produced, meaning that it is OK to change one’s mind as time goes on into the future.
Let me then propose that the risk professional makes decisions in the present to lead to a desired future based on probabilistic information. The finance and backoffice professional uses deterministic information from the past to take an action in the present.
So, why those finance and backoffice professionals who are comfortable with dealing with the past and with what is certain, have to do the work that can be also be delivered by those in risk who take a bet on the future? Or vice-versa, why risk dreamers who believe on making decisions based on the uncertain to lead their companies towards a desired future need to spend their time with what already happened, which for them may be less fun because the past cannot be changed?
Have a smashing New Year, and I wish all the decisions that you are making today will take you into the 2016 of your dreams!
Author of Portfolio Compression
For more information about time travel, Stephen Hawking explains Einstein’s theory in his book “A Brief History of Time”, along with his views and the views of other scientists. A marvellous representation of some of these views can be enjoyed watching Back to the Future, the film that some refer to as the “perfect script”.