Profiledub.com

Managing technology research and news risk is like searching for credibility… or for a lack of it. If you look at a bridge with a solid fundament you can assess the risk visibly and think “when the materials are real and sound this bridge must be suitable.” When you observe a new bridge prototype with a modern avantgarde-like style, a first assessment on risk should be skeptic like: “how is this going to be strong enough?” Only checks and rechecks will help to ease peoples feeling that “this new and modern structure” will be save and secure enough.

In real life this is not any different. In the investment industry we have seen that unimaginable returns could be gained but not without the addition risk of the investment. In both cases from real life structures and investment constructions the risk can also be assessed.

And one of the areas where you have to sort of spy is where you have outsourced your investment “returns.” How will you be sure that a third party can be trusted; do you just believe them on their word?

Riskdata is the company that produces risk management software, or software that risk managers can use to spy and detect bad-practices.

One of the interesting features of this software is the use of a profile to check the credibility of an investment strategy. Riskdata calls this “What appears to be too good to be true can be measured.” Under the approach of seeing-is-believing they use a “the Benford’s law to catch thieves.” This law uses probability as a benchmark.

An additional feature of their software uses profiles. In this approach they have assessed all the variables (factors) that are stakeholders in the investment strategy and how the investment or hedge fund reacts to these so-called return drivers.

“… even when performances themselves cannot be replicated, the risk profile stays the same, i.e. relevant risk factors are the same between the original fund returns and the replication. In the present case, an option strategy like the one described by Madoff, whatever its detail parameters may be, has certain characteristics, just like the DNA print of option trading, that is… “(1) … etc, etc.

Basically what the software does is replicate the strategy of Madoff, by simulating what he says his strategy is to be… This gives a twelve factor spider diagram where the replication can be compared with the claimed profile on factors like volatility and cap. size for example. This last factor is one where we have learned that Warren Buffets’ strategy is becoming increasingly difficult just for the sake of the capitalisation of his fund.

If banks would have applied this software they would have know about irrational return-rates. Apparently banks did use this software. The Riskdata company profile itself alerts with the statement: “understand, anticipate and act.” One could even ask whether this software is needed to understand that predicted returns are irrational.

So far we can conclude that many banks quite certainly did “understand,” the fact that they couldn’t understand these irrational returns. The question is than what did they do with this knowledge?

(1) – http://www.riskdata.com/

© 2009 Hans Bool