The Rules of Risk: A Guide for Investors - Softcover

Über die Autorin bzw. den Autor

DR. RON S. DEMBO is President and CEO of Algorithmics, Inc., a leading provider of innovative financial risk management software. Prior to founding Algorithmics in 1989, he managed a risk analysis group at Goldman, Sachs, and served on the academic faculties of several universities, including Yale University.
ANDREW FREEMAN manages and edits the financial services division of the Economist Intelligence Unit. From 1994-1997 he was the American Finance Editor for the Economist in New York.

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A Dynamic Framework for Forward-Looking Risk Management
 
Praise
 
"A powerhouse in the understanding of risk. With their ingenious blend of psychology and rigorous quantitative analysis, the authors have created an authoritative and innovative handbook of risk management that is essential for both practitioners and theoreticians."--Peter L. Bernstein, Author, Against the Gods, Capital Ideas, and The Power of Gold
 
"This excellent and readable book provides an innovative approach to choosing actions when the outcomes are uncertain. Anyone with an interest in improving their decision-making skills would benefit from reading this. Anyone with a professional interest in risk management must read it."--Stephen A. Ross, Fisher Black Visiting Professor of Finance, Massachusetts Institute of Technology; Sloan School of Management, Sterling Professor of Economics and Finance, Yale University
 
"Ron Dembo and Andrew Freeman have done an excellent job of describing how to think about and measure risk. This will become required reading for businesses and personal investment executives."--Ned C. Lautenbach, Senior Vice President and Group Executive, IBM

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Chapter 1: How to Think about Risk

We have mentioned Paul Reichmann in our earlier comments. The Reichmanns are property moguls who bestrode the world until their huge empire collapsed in 1991. They provided rich material for one of the twentieth century's great business stories. Less well known is the fact that, in 1994, they very nearly pulled off a miraculous comeback. A few well-informed readers might recall that they entered a joint venture with George Soros, the famed speculator whose market-moving abilities have caused major controversies from Britain to Malaysia. But only a tiny number of people know that the Reichmanns disastrously blew a second chance to rescue themselves from oblivion, and they destroyed their venture with Soros in the bargain.

Having made and lost a fortune redeveloping vast swaths of cities such as New York, Toronto, and London, the humbled Reichmanns looked further afield in the early 1990s. In search of a new deal that would relaunch their operations, they hopped smartly onto a hot trend-the rise of new economies and so-called "emerging markets." Their dream was a multibillion-dollar development in the capital of one of the fastest-growing economies in the world. Mexico appeared poised on the brink of emergence into an established and accepted economic force. Its trade links with America and Canada were about to be ratified and liberalized via the North American Free Trade Agreement (NAFTA) treaty (signed by President Bill Clinton in 1993). But the city had very few modern office buildings, and rents were high in those that did exist. What could be more appropriate than to revamp a chunk of the sprawling capital city and erect some of the Reichmanns' signature skyscrapers?

The Reichmann-Soros venture almost succeeded. The Reichmanns followed their typical development process. The venture bought two parcels of land, one of which was on a prime site in the heart of the city. The land was bought on favorable terms from the government, on the promise that it would be developed into a top-rate site. By investing a relatively small amount in architects' drawings and marketing, the Reichmanns hoped to lure a local partner into a 50:50 joint development venture. A giant publicity fanfare led to widespread interest among big construction firms. ICA, a large local firm, bought a 50 percent stake in the first parcel of land on the outskirts of the city. In bidding for the second parcel, ICA proposed to be the builder as well as a joint developer.

It seemed like a sure thing. ICA's cash would fund the entire development, leaving the Reichmanns and Soros with no downside exposure but potentially tremendous upside prospects in the event that the project was a success. A further attraction for the Reichmanns was that they had already dealt with ICA and felt that a deal could be closed quickly.

Unfortunately, the Reichmanns, like much of the rest of the world, were overly convinced that Mexico's leaders, trained in American business schools, knew what they were doing. In 1994, the Mexican economy was under increasing pressure. Although inflation had fallen from 180 percent in 1987 to around 8 percent, growth was sluggish. The Mexican currency was the victim of sudden bouts of nerves among traders, which forced the government to intervene heavily in foreign exchange markets. The need to support the currency grew, and Mexico's foreign exchange reserves dwindled from $25 billion in late 1993 to a mere $6 billion a year later. But because the interventions had kept the exchange rate fairly stable, few people watching the market had any idea that big trouble was around the corner. If you were looking at the exchange rate to guide, say, an investment such as the Reichmanns', recent history would have given you little idea of what lay ahead.

The key to the peso's relationship to the dollar was a tight band within which the government insisted that it would stay. On December 20, 1994, the Mexican government announced that it had widened that band. The peso immediately fell by 10 percent, in a move that shocked traders and investors alike. On December 23, the band was removed altogether, and the peso went into free fall against the dollar, losing 50 percent of its value within just a few days. In addition, interest rates quadrupled over the same period. In the months that followed, it became clear that Mexico had suffered a major economic crisis.

How did the Reichmanns and George Soros react? Their deal with ICA was supposed to be signed and sealed on December 20. Mysteriously, in the days before that date, ICA began to stall. Perhaps it sensed that the currency was vulnerable. When the two sides met on December 21, ICA had changed its position. It wanted the 10 percent fall in the peso to be reflected in new terms for the deal. This was not entirely unreasonable; ICA had to use pesos to fund an investment that, in dollars, had suddenly become more expensive.

Ironically, the Reichmanns' partner might have thrown a lifeline, if only its right hand had known what its left hand was doing. George Soros's canny hedge fund traders had long since sold their peso holdings, believing the currency to be risky. But Soros's property arm had no such insight. It carried on as if everything was normal. No warning was sent to the Reichmann-Soros venture, which consequently had little sense of the ugly scenario that was about to unfold.

Assume the deal with ICA had been successfully renegotiated. What would have been the Reichmanns' position? Arguably, because the original deal had been a rich one, the new terms were simply slightly less rich. The Reichmanns still stood to make an extremely favorable deal with great upside. By signing a contract with ICA, they would have ensured that the project went ahead. They would then have recovered their sunk costs and been largely insulated from further falls in the peso...