10  BIS central bankers’ speeches  BIS central bankers’ speeches  11  12  BIS central bankers’ speeches  BIS central bankers’ speeches  13  14  BIS central bankers’ speeches  BIS central bankers’ speeches  15  16  BIS central bankers’ speeches  BIS central bankers’ speeches  17
Both are bound to be tempted to take on greater risk to generate absolute returns. Of course this syndrome is widely recognised. Investment mandates and management remuneration are often measured against a risk-adjusted benchmark to avoid rewarding such activity. But it can take considerable efforts to spot such behaviour. The proliferation of new and highly complex financial instruments is making it harder to assess the incidence of underlying risk. The assumptions underlying the valuation of positions in such instruments are often unclear. Many of these products have the effect of selling insurance against unlikely financial market events. In so far as there has been a genuine increase in the stability of the economy and financial markets, selling volatility is less risky than it used to be. But it can be more risky than it appears. Our market contacts often cite the example of selling ‘out-of-the-money’ options as a popular strategy recently. Here the seller receives a steady stream of small payments today in return for paying up in the unlikely event that the price of an underlying instrument moves significantly from its current value. With sufficient leverage, a small payment stream can be turned into a tidy return. But as all insurers know, the key to long term return is to spread your risks widely or to avoid correlated risks. In assessing risk in financial markets, a common metric is correlation of positions with the market return. But this is quite inappropriate in this case.