In previous articles, we have described the basic dimensions of financial
price risk used by derivatives end-users and financial institutions to describe
their exposure to fluctuations in financial prices: delta, gamma and vega.
LIQUIDITY RISK
In addition to this quantification of the effect that movements
in spot and implied volatility can have on the value of a derivatives position,
there is the risk of a liquidity vacuum.
A liquidity vacuum is the nightmarish scenario that occurs when
bid/offer spreads for the financial instruments, particularly derivative
instruments, widen out to levels that make it prohibitively expensive to deal.
In the worst kind of liquidity crisis, you can imagine the situation where bank
dealers refuse to pick up the phone and make prices on over-the-counter
products that they themselves sold to their customers.
In
exchange-traded markets, there is a legal requirement for market-makers to show
prices to their customers. In some markets, the bid/offer spread size is
capped. Market-makers are protected by the authorities of the exchange who will
suspend trading in a particular instrument or who will temporarily stop trading
if a particular instrument looks susceptible to a run.
Note that liquidity risk can enter into markets for financial
instruments that are being sold en masse or that are being bought in a popular
mania. In the latter case, it may be impossible to secure supply of the
underlying stock, causing the stock's price to "gap" or jump at
discrete, large intervals. Market commentators who label the current Internet
sentiment as a mania have cited the gaps in trading in these stocks as evidence
of the mania. Brokerage houses seeking to protect themselves from the
unreliable liquidity in these markets have imposed restrictions on margin
trading these stocks.
RISK HOLES
There are many definitions of the term risk hole used by
experienced dealers. Some of them use different terms to refer to the same
phenomenon.
A risk hole occurs in a portfolio of assets if, for a specific
region of one or more parameters relevant to the pricing of the assets in the
portfolio, the exposure to great loss is localized and unhedged.
The classic example of this is the position of the market-maker
in a one-sided market.
Consider the case of a Canadian dollar foreign exchange options
trader during a Quebec separation referendum.
Each of his customers will be paying him for out-of-the-money
US dollar calls/Canadian dollar puts in every period that includes the
referendum date. No matter how much of a premium in terms of implied volatility
(when compared to the at-the-money options for the same period) he charges for
those out-of-the-money Canadian dollar puts, the customer will pay his offer.
What does this mean? He has two kinds of risk hole here (at
least).
First, he is exposed because he will be very short gamma if spot trades
higher. He will get shorter gamma as spot trades higher. This means that he
will lose increasing amounts of money if spot trades higher and his position
gets shorter and shorter US dollars (and longer and longer Canadian dollars) at
an accelerating rate.
Second, if spot does trade higher, it is likely that implied
volatility will jump as well. If spot trades higher, the options market maker
will be getting shorter and shorter vega, at an accelerating rate.
Third, if spot trades higher, the forward points are likely to
move to the right due to the spike higher in Canadian interest rates. This will
have the effect of compounding his gamma problem and his vega problem.
These are just the risk holes that derive from market risk. In
addition, there are operational risk holes as well. The options dealer will
face a liquidity vacuum in the spot market. He will need to buy US dollars
against Canadian dollars aggressively as the Canadian dollar collapses. The
kicker is that he will have a more difficult time doing so as the spot market
dries up. He will have an even more difficult time hedging his exposures in the
options market and the forward market.
One famous currency options interbank dealer named Naseem
Taleb, writing in his book Dynamic Hedging, has referred to this effect
with a humorous analogy. Imagine crowding as many people into a movie theatre
as it will fit, starting the movie and yelling "Fire!" You get the
idea. Finally, our poor market-maker will have to deal with a computer system
and a back-office system that will be increasingly prone to errors as the
amount of processing volume they must handle increases exponentially in times
of crisis.
RISK HOLES FROM IGNORANCE
Risk holes can also arise because of the ignorance of the
end-user about the behavioral characteristics of the product they are dealing.
Now imagine the naïve fund manager who thinks that the market is overdoing
this premium for out-of-the-money US dollar calls/Canadian dollar puts.
Naturally, he sells them. He has all of the problems described above that face
the market-maker. Chances are he does not earn the bid/offer spread on the
transaction (that has naturally inflated due to the panic about the uncertainty
of the separation referendum's outcome). Nor will he have the direct access the
options market-maker has to the underlying markets.
What is worse, let us imagine that he does not have the systems
or the training to assess and measure his exposure to these risks. He could
stand to lose all of his fund's money and more in the worst-case scenario.
Understanding risk involves breaking it down into terms that we can manage.
Managing risk means, in many cases, avoiding risk holes and smoothing exposures
so that they fit into reasonable tolerances, while still positioning ourselves
to take advantage of favorable market moves if and when they occur.
Article by Chand Sooran, Principal Victory
Risk Management Consulting, Inc. |