By Dwayne Strocen
Website: https://www.genuinecta.com
Understanding Market Risk and the solutions
available to mitigate or eliminate financial loss in today's global market.
First of a two part article
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.
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 un-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 un-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Many jurisdictions have repealed this rule however mutual fund managers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 and do not understand the hedging process and may
re-deem 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 such as 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.
