Understanding Market Risk and solutions available to mitigate or eliminate financial loss
Fund managers, whether they be equity or bond traders, know all too well that returns are not simply a result of their asset selection prowess. Many external factors come into play. But what are the issues facing the professional money manager. Management of risk is one of the most important, and not all fund managers analyze their market risk. This is often explained as a lack of education and a failure to understand the mitigating solutions for off-setting risk.
Market risk is defined as “the unexpected financial loss following a market decline due to events out of your control.” Stock or bond market volatility or market reversals can be the result of global events happening in far flung corners of the globe. Top analysts and fund managers simply do not have the resources to crystal ball gaze and predict those events.
Examples of several major unexpected events that sent shock waves throughout the financial community have been:
- 1982 Mexican Peso devaluation;
- 1987 stock market crash known as “Black Monday”;
- 1989 USA Savings and Loan Crisis;
- 1998 Russian Ruble devaluation;
- 1998 $125 billion collapse of Hedge Fund Long Term Capital Management;
- 2006 collapse of Hedge Fund Amaranth with losses of $5.85 billion;
Understand The Process:
In 1994 Bank J.P. Morgan developed a risk metrics model known as Value-At-Risk or VaR. While VaR is considered the industry standard of risk measurement, it has its drawbacks. VaR can measure total dollar value of a funds risk exposure within a certain level of confidence, usually 95 or 99 percent. What it cannot do, is predict when a triggering event will occur or the magnitude of the subsequent fallout. For some company’s and funds, a steep decline or protracted recession can be devastating. Even forcing some in hedged firms into bankruptcy. A triggering event can have a ripple effect forcing people out of work and economies into recession effectively putting more people out of work. No person and no economy is immune.
If you’re invested in a mutual fund, chances are your fund is in hedged. Until recently, mutual fund legislation prevented mutual funds from hedging. Many jurisdictions have repealed this rule however mutual fund managers have been slow or decided to continue with “business as usual”. The reason is that most investors of mutual funds are unsophisticated. They do not understand the hedging process and may redeem their money from an investment strategy they do not understand.
Hedge funds on the other hand do not have these restraints. Investors are more sophisticated and are more open to the nature of hedge fund strategies. Some of which are not disclosed due to a fear of piracy by competing hedge fund managers.
Risk reduction solutions are not complicated but do require the services of a professional who understands the process. This is the role of a Commodity Trading Advisor, also known as a CTA. While most CTA’s are hedge fund portfolio managers, few specialize in risk management analytics. The focus of a risk manager is on the analysis of solutions to reduce or eliminate market and / or operational risk. No matter the role, all Commodity Trading Advisors are specialists in the derivatives market.
The first step is the value at risk calculation to determine a funds risk liability. A risk mitigation strategy known as a hedge is then implemented. After all, identification of one’s risk is only beneficial if a solution to off-set that risk is put into place. Hedging requires the use of derivatives, either exchange traded or over-the-counter. These can take many forms. The most commonly used hedging instruments are index futures, interest rate futures, foreign exchange, exchange traded commodities. Examples are Crude Oil, options and SWAPS.
A more detailed explanation of derivatives and hedging will be discussed in our next article. Now that we’ve identified an easy solution for your market risk worries, the implementation of the right strategy can be as easy as a call to a qualified and registered Commodity Trading Advisor.
Dwayne Strocen is a registered Commodity Trading Advisor specializing in analyzing and hedging Market and Operational Risk using exchange traded and OTC derivatives. View more detailed information about Risk Management and Foreign Exchange trading.