The New Economics of Sovereign Wealth Funds

4

Risk Management for SWFs

To the majority of practitioners, and almost all regulators, the quasi-meltdown of the financial markets in the autumn of 2008 came as a shock, because they were genuinely convinced that they were relying on state-of-the-art models which would capture accurately the exposure to risk and provide early signals of impending mayhem. They were genuinely convinced that fancy formulas and complex numerical solutions to partial differential equations were an accurate description of reality. They were genuinely convinced that they had reliably estimated within a narrow confidence interval stable correlation coefficients between asset prices, including those of derivatives contracts, notwithstanding that not even the lawyers (or the quants) that had designed them knew what the clauses entailed. And, above all, they took for granted that a triple A assigned to a tangle of intricate structured products really meant that their default risk was as remote as the default of the US or German sovereigns.¹

This false sense of security spread like gangrene to the trading floors, the auditors and the boardrooms, where few bothered to challenge the assumptions or examine the underpinnings of the rosy picture. It was much more comfortable to receive a hefty pay check for nodding silently and congratulating top management on yet another quarter of forecast-beating profits. Sadly even in hindsight it was the right behaviour because, as experience proved, ultimately almost nobody ...