The Reward of Risk

November 14, 2018

Traditional risk/reward comparisons treat the cost of an investment’s risk as a decrement to its potential return – overlooking the potential return available on investments in which risk may also provide a source of alpha. While cost-effectively reducing an investment’s risk and/or its relative capital cost can promote a higher return, investors that seek to harvest alpha potentially embedded in the risk itself may be well rewarded for their effort.

History has proven that risks are most efficiently managed in groups comprised of diverse exposures to which actuarial science and the Law of Large Numbers can be effectively applied to produce consistently predictable results. Those risk-management processes have been employed by insurance and reinsurance companies to produce profitable returns for centuries.

Ancient Tool – Modern Solution

The risk-pooling processes employed by reinsurers to globally distribute and diffuse insured risks were originally employed by ancient ship owners that pooled their risks of potential ruin due to losses of their ships and cargo at sea. Where an individual owner would have been devastated by the loss of a ship, pooling that risk enabled owners to distribute each exposure among their numbers, so that each paid a relatively small amount in the event of a loss.

Many of the pooling functions historically used by reinsurers are now also being used to lower default risks for credit investors. Through a transparent distributed ledger maintained within a regulated neutral facility, investors can anonymously:

a) Transfer the full default risk of a referenced underlying security to a collateralized protection-account in return for their payment of a negotiated series of fixed premiums;
b) Purchase a fixed income security in which the default risk of a referenced underlying security is embedded; and either
c) Retain that embedded default risk, or fully transfer it to a dynamic risk-pool, receiving in return a small pro-rata share of all such risks transferred to the pool.

Unlike the pools employed for structured securities, no assets or cash flows of an underlying security or referenced entity are included in a risk pool. Only the default exposure of the specified underlying securities are included in the risk-mitigating vehicle.

Releasing Embedded Alpha

Operation of the Law of Large Numbers within a risk-pool produces increasingly predictable default experience as the size of the pool increases. The pool’s collective result also naturally regresses toward the mean of the total experiences of its constituent exposures. That increased predictability and regression proportionately reduce the capital requirement of each individual risk in the pool. In turn, that lower capital requirement:

a) Reduces the required face amount of each pooled-risk security, without commensurately reducing the security’s independent flow of coupon payments; and thus
b) Increases the holder’s yield through its ongoing receipt of the latent alpha released from the security’s lowered exposure.

To learn more about the reward of risk, contact us.