By Dwayne Strocen
Website: https://www.genuinecta.com
To manage an effective risk management solution
requires more than the calculation of VaR.
Ultimately a successful risk management program requires the execution
of an effective hedge. Technical
analysis is a vital element of this strategy.
Recent market reversals brought about by the Sub-Prime mortgage melt
down is clearly a significant market correcting event. No matter if you work in the risk department
of a large bank with many employees or a small fund of funds as co-manager, you
share the same basic concerns regarding the management of your portfolio(s).
1.
how to maintain top quartile performance;
2.
how to protect assets in times of economic
uncertainty;
3.
how to expand business reputation to attract new
client assets;
It remains common in the
financial industry to hear experienced portfolio managers state their risk
management program consists of timing the market using their superior asset
picking skills. When questioned a little
further it becomes apparent that some confusion exists when it comes to hedging
and the use of derivatives as a risk management tool.
Risk management analysis can
certainly be an intensive process for institutions like banks or insurance
companies who tend to have many diverse divisions each with differing mandates
and ability to add to the profit center of the parent company. However, not all companies are this
complex. While hedge funds and pension
plans can have a large asset base, they tend to be straight forward in the
determination of risk.
While
Value-at-Risk commonly known as VaR goes back many years, it was not until 1994
when J.P. Morgan bank developed its RiskMetrics model that VaR became a staple
for financial institutions to measure their risk exposure. In its simplest terms, VaR measures the
potential loss of a portfolio over a given time horizon, usually 1 day or 1
week, and determines the likelihood and magnitude of an adverse market
movement. Thus, if the VaR on an asset
determines a loss of $10 million at a one-week, 95% confidence level, then
there is a 5% chance the value of the portfolio will drop more than $10 million
over any given week in the year. The
drawback of VaR is its inability to determine how much of a loss greater than
$10 million will occur. This does not
reduce its effectiveness as a critical risk measurement tool.
A sound risk
management strategy must be integrated with the derivatives trading
department. Now that the Portfolio
Manager is aware of the risk he faces, he must implement some form of risk
reducing strategy to reduce the likelihood of an unexpected market or economic
event from reducing his portfolio value by $10 million or more. 3 options are available.
- Do nothing - This will not look favourable to investors when their investment suffers a loss. Reputation suffers and a net draw down of assets will likely result;
- Sell $10 million of the portfolio - Cash is dead money. Not good for returns in the event the market correcting event does not occur for several years. Being overly cautious keeps a good Portfolio Manger from achieving top quartile status;
- Hedge - This is believed by all of the worlds largest and most sophisticated financial institutions to be the answer.
Let's examine how it's done.
Hedging is really very
simple, and once you understand the concept, the mechanics will astound you in
their simplicity. Let's examine a $100
million equity portfolio that tracks the S&P 500 and a VaR calculation of
$10 million. An experienced CTA will
recommend the Portfolio Manager sell short $10 million S&P 500 index futures on the Futures
exchange. Now if the portfolio losses
$10 million the hedge will gain $10 million.
The net result is zero loss.
Some critics will argue the
market correcting event may not happen for many years and the result of the
loss from the hedge will adversely affect returns. While true, there is an answer to this
problem which is hotly debated. After
all, the whole purpose of implementing a hedge is because of the inability to
accurately predict the timing of these significant market correcting
events. The answer is the use of
technical analysis to assist in the placement of buy and sell orders for your
hedge.
Technical analysis has the
ability to remove emotional decisions from trading. It also provides the trader with an unbiased
view of recent events and trends as well as longer term events and trends. For example, a head and shoulders formation
or a double top will indicate an important rally may be coming to an end with
an imminent correction to follow. While
timing may be in dispute, there is no question a full hedge is warranted. Reaching a major support level might warrant
the unwinding of 30% of the hedge with the expectation of a pull back. A rounding bottom formation should indicate
the removal of the hedge in its entirety while awaiting the commencement of a
major rally.
It is evident that
significant market correcting events occur infrequently, in the neighbourhood
of every 10 to 15 years. Yet many minor
corrections and pullbacks can seriously damage returns, fund performance and
reputation.
If you have ever been
confronted with upcoming quarterly earnings or a topping formation which has
caused you to consider liquidation then you should have first considered a
hedge used in conjunction with the
evidence from a well thought out analysis of technical indicators. Together they are a powerful tool, but only
for those who have the insight to consider asset protection as important as big
returns. I guarantee your competition
understands and so does your clients who are becoming more sophisticated each
year. It's important that you do too.
Dwayne Strocen is President of Genuine Trading
Solutions Ltd. and an honoured member of
Stanford's Who's Who. He's a registered
CTA and derivatives analyst. He also
manages the Genuine USA Index Managed Account Program, and provides risk management
analysis and hedging solutions for assessing market risk on behalf of
corporations and financial institutions.
View more information about Who We Are and the benefits of
Hedging your risk.