If you have an asset that has some market risk but a large portion that is unexplained, the risks you face are different. You still can either leave the market risk exposed or hedged, but the majority of the risk cannot be explained. Hence, it cannot be truly hedged. You can conduct further analysis to measure the risks from other factors but you may still be left with a high percentage unexplained. You may have thought of everything with respect to your risks, but there is a lot leftover.
Market liquidity is dynamic. By some measures and for some markets, liquidity could be better than a decade ago, but there are some clear hot spots. Traders break up orders to reduce the price impact of trades and high frequency market-makers can make tight bid-ask spreads, but a shock can cause this liquidity to disappear quickly.
If you assume a normal asset return distribution world and it does not exist, you will be surprised with return performance especially in the tails and unlikely for the better. Of course, when in doubt, the rule of thumb for any sample of return data is to assume normality. Using the central limit theorem is a good starting proposition for any discussion, but it is not where the return discussion should end. The distribution assumptions are a place for danger with decision-making.
Everyone is expecting a big negative credit event. Leverage is high. Overall debt is high. Growth is still low. Loose monetary policy continues at extremes through quantitative easing that has supported the extension of the global credit cycle. Nevertheless, the knowledge of a large downside tail event does not mean that investors are prepared with an action plan for when the downturn arrives. Investors can still be unprepared for what they will do with their portfolio when the time comes.
I was having a discussion about the merits of managed futures relative to other hedge fund styles. Managed futures funds will often have positive skew versus other hedge fund styles. The measurement of skew is tricky and is not present with all managers but for trend-followers who allow profits to accrue, it is more likely. The argument for positive skew is embedded in the behavior of the managers.
The World Economic Forum has produced their Global Risks Report 2019 (14th edition) this week. The report provides an exhaustive listing of the greatest potential threats to the global economy and discusses the potential linkages between these risks. The WEF describes five categories of risk: economic, environmental, geopolitical, societal, and technological. It is worth spending time getting their assessment although be warned that risks are everywhere and not going away. There is no good news with these potential threats.
…was lookin’ for risk in all the wrong places, Lookin’ for risk in too many faces, searchin’ their eyes and lookin’ for traces of what I’m dreamin’ of. -Lookin’ for Love, Johnny Lee Risk will surprise you. It is supposed to do this. While we always think of volatility as risk, the real measure of risk […]
Skill is what you have when things go right.
Luck is what you don’t have when things go wrong.
Probability does not have a personality.
If you have been on the road looking for cheap food 24 hours a day in the South, you have likely been to Waffle House. It is not be best breakfast, but if you need a quick meal, this is a good place. You usually will not see a money manager or a Wall Street banker at a Waffle House counter and that may be an added appeal.
You might think some research is obvious after the fact, but in reality, good research can allow us to deepen our understanding on a topic and may provide subtle insights that were unexpected. One topic of interest is competition and rivalry.
If you want to understand overall credit spreads you have to have both a macro and a micro view. The macro view looks at the business cycle and the chance of default for risky assets based on economic growth. The micro view looks at the credit supply coming to market, the demand for loanable funds at any time, and the structure of deals. The macro focuses on credit risk expectations and the micro will be more centered on the flow of funds. A macro-micro framework helps focus our interest in actual and perceived credit dislocations.
So if there’s a big market sell-off and as a response the VaR overreacts and shoots up, then many investors are kind of forced to sell because they have to stay within their VaR limits and this selling will then be done in an already collapsing market…rigorous use of VaR measures undermines the stability of markets.
It’s the type of risk management practice that works well as long as it is not needed; just like Bernanke observed after the credit crisis about their standard models that proved to be “successful for non-crisis periods”.
-Harold de Boer Transtrend
Opalesque Roundtable series ’17 Netherlands
There has always been a lot of talk about the competitive advantage of a firm. For money managers, it has been about their edge. However, there is a new focus by some consulting forms about a firm’s risk advantage. (See BCG’s Henderson Institute – “Taking Advantage of Risk” and the BCG’s Perspectives piece “From Risk Take to Risk Manager”). This strategy work has focused on a firm’s “risk advantage” as an alternative to competitive advantage. Firms that manage their strategic risk options can add value relative to those that look at risk management as a police function.