By Larry E. Fondren, Founder & CEO, DelphX Capital Markets Inc.
Traditional risk/reward comparisons treat the effective cost of an investment’s risk as a decrement to its potential return – overlooking the additional potential return available on certain investments in which risk may provide an additional 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 latent 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 results for centuries.
Ancient tool – modern solution
The risk-pooling processes employed by reinsurers, to globally distribute and diffuse insured risks, were originally used thousands of years ago by ancient ship owners who 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 the risk enabled owners to distribute each exposure among their numbers, so that each paid a relatively small amount in the event of such a loss.
The primary pooling functions historically used by reinsurers are now also available to credit investors seeking to reduce their default risks. Through a transparent distributed ledger accessible within a regulated global facility, investors can anonymously:
• Transfer the full default risk of a referenced underlying security to a secured protection-account, and, in return for their payment of a negotiated series of fixed premiums;
• Purchase a collateralised credit security in which the default risk of a referenced underlying security is embedded; and either:
• Retain the embedded default risk, or fully transfer it to a dynamic risk-pool, receiving in return a small pro-rata share of all risks transferred to that pool.
Unlike pools employed in structured securities, no assets or cash flows of an underlying security or referenced entity are included in a risk-pool. Only the default risk of the underlying securities embedded in the pooled-risk securities are included in a risk-pool.
Releasing embedded alpha
Operation of the Law of Large Numbers within a risk-pool produces an 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:
• Reduces the required face amount of each pooled-risk security, without commensurately reducing the security’s independent flow of coupon payments; and thus:
• Increases the holder’s yield through its ongoing receipt of the latent alpha released from the security’s diminished risk.
To learn more about the reward of risk, contact Larry Fondren at firstname.lastname@example.org.