Neerav Agrawal, ENG’03, W’03, Scotiabank
Neerav Agrawal, ENG’03, W’03, as Head of U.S. Risk within the Global Prime Finance business at Scotiabank, is at heart, a scientist, which to paraphrase Einstein, is someone who raises new questions, regards old problems from new angles, and thinks what if. Neerav graduated in 2003 from the Fisher Program of Management and Technology. He has also performed risk management roles at BNP Paribas and Bank of America.
What do you do?
The Global Prime Finance business at Scotiabank provides a spectrum of services to its clients, including clearance, execution and financing. One typical example of this is to provide financing to hedge funds and mutual funds for their trades in stocks and bonds. Since I focus on U.S. equities, I look for big short-term moves in the S&P 500 and the VIX, which tracks its volatility.
How does a typical hedge fund financing transaction work?
If the client goes long (meaning an investor profits if the price of the stock rises), we are lending it cash, and if it goes short (meaning an investor profits if the price of the stock declines), then we are lending it securities. One of the most common strategies for hedge funds is long-short equity. They perform fundamental or technical analysis across equities and figure out what their buys are and what their sells are. They go long by buying stocks that they like, and sell short companies they don’t. Say, the hedge fund goes long on a security by buying $100 worth, and I say that margin is 10%. Then, the hedge fund puts up $10, and the bank puts up $90. On the short side, we lend the hedge fund the stock, and if the margin again is 10%, then it has to put up $10. The margin we require is our protection against adverse price moves. The 10% is the amount the value of the stock can change before the margin is extinguished. If the long stock drops from $100 to $85 and the hedge fund put up only $10, then we have $5 of potential exposure to loss.
What risks do you assess and manage?
When we are determining how much financing to provide against a portfolio, we look at the market risk, and we consider the client’s credit risk. We have two mitigants — we take margin against our financing, and if it doesn’t cover the market risk, then we still have the credit quality of the client itself.
We focus on two main sources of market risk that can mitigate or exacerbate financial risk: diversification and liquidity. If Lehman Brothers was the only stock in your portfolio in 2008, you might have taken a loss, but if your portfolio contained different countries or different sectors, or it included a long-short strategy, then you might have fared better. We take a strong look at the diversification of a client’s portfolio in determining the amount of financing to provide. For example, our systems will recognize that, as a client’s portfolio becomes more diversified, it will be less risky, and we might require less margin.
On the liquidity side, when we are lending against securities, we take those securities as collateral. Say, a client buys XYZ stock. Once the execution occurs, we receive the stock on behalf of the customer and hold that stock as collateral in the customer’s we can liquidate its position in that stock for cash to repay our loan. If at that time XYZ stock is illiquid, then its price will decline as we sell it, and we won’t be able to pay ourselves back fully.
Liquidity can be misleading. In the summer of 2007, the market itself did not move much, but hedge funds pursuing statistical arbitrage strategies, although they had their own proprietary models, held similar positions. They thought they were liquid, but the trades they were in were crowded. So when one of them needed to unwind its portfolio rapidly, it created adverse moves in other funds’ portfolios. We don’t lend against anything that we can’t price, which means we deal only with public securities. If we can’t determine the price ourselves, we go to third-party vendors or look at quotations from brokers. We are not concerned about slow moves in the market, even if they add up to large moves, because we can manage that. A sudden move has greater impact, such as the Flash Crash in May 6, 2010, an intraday move in the equity markets, or news about a large company, such as Enron, for example.
And Scotiabank’s upside?
Our upside is, if the client does well, then it will grow as a fund, and our relationship will grow.
I might have gone into risk management, but there was that Black-Scholes Model. Do you use that?
There are strong quantitative and qualitative aspects to risk management. On the quantitative side, Black-Scholes is important not so much because of the specific formula, but in the concept of looking at sensitivities to inputs — such as looking at the impact on a portfolio if interest rates rise, if the S&P drops, or if the price of gold changes.
We do use statistical analysis — the most famous is value at risk (VaR), which in my opinion, is limited. Because the VaR calculation depends on historical data, it usually won’t predict anything worse than what happened in the past. Then, there are stress tests, which you may have heard about — regulators ask banks what would happen if a series of events occurs. We run our own stress tests internally. The qualitative aspect is deciding which stress tests to run. For example, the S&P dropped 18% in October 2008 over a period of five days. That had not happened since 1987. Looking at historical data, you might not go back that far. So, as a risk manager, you have to be able to step back from your models, and take a broader view of the risks you are looking at.
Could you define “prime broker?”
Imagine you are a hedge fund with a brokerage account at one firm, because it charges good commissions on stocks, and at another firm, because it charges good commissions on bonds. The problem is that you want to see all of your positions in one place, you want to enjoy diversification benefits for margin, and you want to consolidate your cash. The solution is a prime broker who steps in to handle all your positions.
Similarly, Scotiabank is a prime broker for customers, which means we clear, settle and finance their trades, as well as facilitate their reporting. Since 2008, an interesting trend is for funds to look beyond costs to the credit risk of their prime brokers. This is called “counterparty credit risk,” and hedge funds paid more attention to it after the Lehman Brothers bankruptcy. This trend has benefited Scotiabank, since the bank is viewed as conservative and deliberate from a risk management perspective.
What do you enjoy about your work?
While my coursework at Wharton was important in developing my skills, when I graduated, I wasn’t thinking about risk management. I fell into it because it fits my interests and skills. I’m a skeptic in many ways. One of the things I like about my job, which sometimes drives other people crazy, is that I question everything.
For my job, it is important to ask the question, “In what ways could I be wrong?” If something looks too good to be true, maybe there is something about it that I’m missing. What can go wrong in the market that can cause us to lose money on this portfolio? What else should I be seeing in this contract? What else should we ask our clients about their strategies? How can we structure a transaction to be mutually beneficial to the client and ourselves? It’s a key strength for a risk manager to be able to ask the right questions. It’s a matter of being curious.