Future of Risk Management in Volatile Market.

Posted: December 29, 2010 in Finance

The reckless lending and business practices of financial institutions, practices that once seemed acceptable, have led the global economy into unprecedented turmoil. The initial shock has been replaced by resignation and the knowledge that the impact of this crisis will be felt for years to come.

Prospective view with retrospection :

Regulators will be expected to intervene and prevent a boom-and-bust cycle rather than watch it from the sidelines. Policymakers will have to reconsider the roles and responsibilities of different agencies monitoring the health of the economy.

The financial system collapsed due to poor business decisions, excessive leverage, a large concentration of toxic positions and weak control structure. Some of these were the same factors that caused previous market shocks, and our irrationality was that we did not address them sooner, sufficiently or aggressively enough.

The risk management framework at many large institutions failed to control these factors. At the same time, the government and the regulators  so called “risk managers for the economy”,  did not step up and intervene decisively when there were early warning signals.

As we move forward to revamp our risk management, we need to break away from the current failed framework and culture. In the past decade we have progressively moved toward a risk management structure that is procedural, fixed to quantitative models, irrespective of the business model, instruments or markets. Further, the regulatory framework has added to the systemic risk by legitimizing flawed quantitative approaches.

It is easy to fall prey to associating risk management with calculating quantitative metrics, producing reports and managing systems and market data. In principle, risk management should be about helping institutions determine a prudent risk/return operating spectrum. It should put them in a position of strength, at all times, by avoiding catastrophic risks. Good risk management practices should aim to introduce a risk-aware culture, rather than an accident-prone culture. It should enforce disciplined risk taking/profit making within the stated business goals.

Two key Parameters that that needs to be addressed for future market volatilities:-

Leverage :  Issues related to excessive leverage or poorly executed trades are often discovered only during times of crisis, when the portfolio is experiencing stress. Although it is common to discuss leverage as if it represents risk, in reality it is the other way around. Leverage is simply the ability to buy and sell securities on margin. It is not meaningful to compare the leverage of two portfolios or institutions, even if they were potentially pursuing similar strategies.

Liquidity :  The market participant’s decision to exit could be driven by events that are fundamental, technical or sentimental. Whatever the impetus, the situation invariably has a tendency to go into a downward spiral as market events and portfolio events feed into each other. Liquidity risk is difficult to measure, partly because the liquidity observed during normal times cannot always be relied upon to estimate risk during market stress. An instrument might be liquid during normal times – but if it is complex, it is almost always illiquid during market shocks.

Well established Risk measures that needs reconsideration:-

VaR : . The industry standard metric, VaR, is not practical many a times for the purposes of limits.  VaR is not a coherent risk measure, and it doesn’t provide any information relative to the tails of the distribution. It does not lend itself to pre-trade application and is a poor risk control tool in many scenarios. Many relative value or long/short trades can be constructed so that VaR is reduced when in fact the risk is going up.

Ratio Of  Sensitivity : DV01 (A bond valuation calculation showing the dollar value of a one basis point decrease in interest rates), Delta (The delta of an option is the rate of change in an option’s price relative to a one unit change in the price of the underlying asset) or Vega (Vega measures the sensitivity of an option’s price to changes in Implied Volatility) can also be erroneous  because some of these measures are based on models that fail during gapping events.

Basis Risk : Basis risk is the risk that the change in price of a hedge may not match the change in price of the asset it hedges, can remain hidden and hence create a big challenge.

Prior Quantitative Approach failure learning that needs to be taken care in future :

There is one thing we have learned from market shocks, it is that quantitative models always fail when markets break down. While such a model is perhaps a useful measure for a business unit to understand its return profile in normal market conditions for a class of instruments, these types of models failed during the Long-Term Capital Management (LTCM) crisis to estimate many dimensions of risk.

VaR models are not effective risk control tools to use in stressed markets; they mainly provide information on performance metrics in normal market conditions. A 2% VaR at 95% confidence interval indicates that the loss will be less than 2% of capital with a 95% probability, but provides no information on the tails.

Scenario analysis and what-if analysis can be insightful for taking tactical action. This is not a new concept and has been widely discussed since the post-LTCM crisis days.

The bottom line is the analysis and assessment of risk requires combining art with science and a willingness to go against the herd (or majority view) within the institution.

If there is one risk issue that has been ignored or not sufficiently addressed in our risk management structure, it is the human element. Human behavior is always unpredictable and can bring about the escalation of a crisis. Shifting sentiments, extreme reaction and herd behavior will break correlation structures in unexpected ways. Moreover, the effects of the media and political forces can prevent management from effectively responding to a crisis.


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