When Theory Meets the Market – Part 3: Hindsight Is Not a Market Standard

By the time the transaction becomes the subject of litigation, the outcome is known. Market movements which were uncertain at the time are now historical facts, and risks which may once have appeared remote can seem obvious or even inevitable.

The difficulty is that the outcome of a transaction does not necessarily tell us whether the original decision was reasonable.

 

What Was Known at the Time?

When assessing a financial decision, one of the first tasks is to establish what information was available to the market participant when the decision was made. That may include prevailing prices, volatility, liquidity, interest rates, expected dividends, funding costs and market expectations. It may also include the participant’s existing positions, investment objectives, risk limits and contractual obligations.

This distinction is particularly important in derivatives markets, where the value and risk of a position depend upon expectations of future market conditions rather than simply the prevailing price of the underlying asset.

Consider an investor who sells options in the expectation that market volatility will remain relatively subdued. The strategy may generate regular income but expose the investor to substantial losses if the market moves sharply. If volatility subsequently increases and the strategy produces significant losses, it is tempting to conclude that the original decision was misguided. However, the appropriate analysis requires an examination of the risks and potential returns as they appeared when the positions were established, including whether those risks were properly understood and managed.

The fact that an adverse outcome occurred does not, by itself, establish that the strategy was unreasonable. Equally, the fact that a strategy was profitable does not establish that the risks undertaken were appropriate.

 

Market Expectations Are Not Market Facts

A further difficulty arises when assumptions about future market conditions are subsequently treated as though they should have been known with certainty.

Expected dividends provide a useful example. The pricing of equity futures reflects, amongst other things, expectations concerning dividends over the life of the contract. Those expectations may be informed by company announcements, historical distributions, analyst forecasts and prevailing market prices. However, an expected dividend is not necessarily the dividend ultimately paid. Company performance, changes in distribution policy and wider economic developments may affect the eventual outcome. An analysis which substitutes the dividend actually paid for the dividend reasonably expected when the futures contract was traded can materially distort an assessment of the original pricing.

Similar issues arise with interest rates, exchange rates, volatility and credit risk. Market participants make decisions based upon information and expectations available at the time, not the outcomes subsequently observed.

This does not mean that all contemporaneous assumptions were reasonable. An expectation may have been inconsistent with available market information or based upon an inappropriate model. The point is that its reasonableness must be assessed using the information then available.

 

The Difference Between Risk and Outcome 

Risk management is particularly vulnerable to hindsight.

A hedge is intended to reduce or manage an identified exposure, but it may not eliminate that exposure entirely. Differences in maturity, basis, liquidity or the characteristics of the instruments involved can result in losses even where the hedge was appropriately constructed.

Similarly, a decision to reduce risk may subsequently prove costly if the market moves favourably. That does not necessarily make the decision wrong.

For example, a company with a substantial foreign currency liability may enter into a forward contract to protect itself against an adverse exchange-rate movement. If the currency subsequently moves in the company’s favour, the forward may appear to have been an unnecessary expense or to have deprived the company of a financial benefit. But the purpose of the transaction was to manage uncertainty, not to predict the eventual exchange rate.

The appropriate question is whether the hedge was suitable for the exposure and objectives at the time, rather than whether it produced the most profitable outcome with the benefit of hindsight.

 

Reconstructing the Decision

Contemporaneous records are particularly important in distinguishing what was known at the time from what became apparent afterwards.

Trading records, market data, investment committee papers, risk reports, internal communications and valuation models may help establish the information upon which a decision was based.

However, care is needed when interpreting those records. A risk which was identified in a report was not necessarily regarded as likely to occur, and the existence of a warning does not automatically mean that the relevant decision was unreasonable.

Conversely, the absence of a particular risk from contemporaneous documentation does not establish that it was unforeseeable.

An expert may need to consider whether the risk was understood, how it was assessed, whether alternative courses of action were available and how the decision compared with prevailing market practice.

The objective is not to reconstruct what the participant should have done knowing what we know today, but to understand the decision within the circumstances in which it was actually made.

 

A Poor Outcome Is Not Necessarily a Poor Decision

There is an important distinction between assessing the quality of a decision and assessing its financial consequences.

A well-considered transaction can produce a substantial loss because an unlikely event occurs. An inadequately considered transaction can generate a large profit because the market moves favourably. Neither outcome, considered alone, establishes the quality of the original decision.

This is particularly relevant where expert evidence is used to assess the conduct of traders, investment managers or financial institutions. An analysis which begins with the loss and works backwards to identify what should have been done differently risks confusing hindsight with the standards and information available at the time.

That does not mean that losses are irrelevant or that decisions should be excused simply because markets are uncertain. Poor judgement, inadequate risk management and unreasonable assumptions can all be identified through a proper examination of contemporaneous evidence.

The distinction is that those conclusions should arise from the analysis of the original decision, rather than from knowledge of its eventual outcome.

 

Financial decisions should be judged by what was reasonably known and understood at the time, not simply by what subsequently happened.

In Part 4 of When Theory Meets the Market, I will consider the apparent precision of financial models and why a numerical result can sometimes convey considerably more certainty than the underlying assumptions justify.