Research Paper on "Limiting Market Risk"

Research Paper 10 pages (2973 words) Sources: 4

[EXCERPT] . . . .

managing market risk. There are some fundamental differences between market risk and firm-specific risk, although some of the underlying principles of managing this risk are the same. The most common measure of market risk is the value at risk (VaR) calculation, which measures risk in terms of the value of the firm that is at risk during a given point in time, to a specific confidence interval. Outside of that interval, however, incidents can take place that can result in a destruction of firm value greater than the VaR. Examples such as the Amaranth natural gas trading collapse illustrate the importance of a multifaceted strategy for managing market risk. What the Amaranth case shows us is the importance of understanding all of the aspects of market risk that the firm faces, including liquidity risk in big positions. For liquidity risk, there is no equivalent accepted measure to VaR, and this represents challenges to portfolio managers seeking to control their market risk.

This paper analyzes the issue of market risk, some of the measures that can be used to evaluate that risk, and some of the strategies that can be used to manage market risk. Market risk management is an emerging field, and unlike with firm-specific risk there is no one specific objective for portfolio managers with respect to its management. The focus of those studying market risk management, therefore, is to understand the tools that are utilized in measuring and managing market risk. This paper will focus on explaining the underlying concept of market risk and the different tools and theories that can be used to both manage and control market risk. Particular attention will be paid to the case of Amaranth, which illustrates among other things the dangers associated with seeking to eliminate market risk by engaging in strategies that lack diversification.

Introduction

Modern portfolio theory is built around the idea of eliminating firm-specific risk from the portfolio. Every firm comes with risk, but through diversification that risk can be reduced or eliminated, leaving only the risk that is inherent in the market. Risk managers today, having accepted that they can largely eliminate firm-specific risk, have turned their attention to the elimination of market risk. Hedge funds, for example, are designed to have negative betas, enabling them to be used by portfolio managers to help offset market risk. The recent global financial crisis has cast further attention to the issue of market risk, as investors have found it increasingly difficult to find firms and investments that will grow in a slumping market. Broad-based declines in consumer spending depress so many segments of the economy that escaping these declines seems impossible. That is, however, the objective of those seeking to minimize market risk. In a global economy, where portfolio managers have the opportunity to invest anywhere in the world, in any type of product, the opportunity to eliminate a significant portion of a portfolio's market risk should exist. This paper will analyze some of the underlying theories about market risk, and will outline and evaluate some of the different strategies that portfolio managers and finance theorists are undertaking in order to reduce the level of market risk in portfolios.

Summary of Issue

A common measure of risk in a given portfolio is known as "value at risk." This is typically defined as the "maximum dollar portfolio amount that can be lost in a given period of time with a specified level of confidence" (Russon, 2008). The normal confidence level is 5%, and the VaR can be modeled in one of three ways. Measuring risk is the first step to addressing risk. Under normal circumstances, the 95% of the time, market events can be addressed because the portfolio will be designed to eliminate normal risk. It is the remaining 5% of the time that is of the most concern for portfolio managers.

Firm-specific risk is often defined in terms of the company's beta, which reflects the responsiveness of asset price vs. A representative index, typically a stock price vs. A broad stock market index (Jarvela, Kozyra & Potter, 2009). The objective of diversification is to reduce all firm-specific risk, which should deliver to the portfolio a beta of 1.0, the same as the market. Ideally, portfolio managers are seeking to enjoy gains above those of the market, but with downside risk equivalent to the market. In a fully diversified portfolio, the market risk is all that remains, but there remains the 5% of the time that estimates of portfolio reaction to market changes will be off. It is at these times when the portfolio's value is most at risk.

Market risk itself derives from a wide range of elements within the global capitalist economic system. Sullivan (2008) points out that the "capital asset pricing model suggests that investors demand a risk premium in exchange for taking certain investment risks." Part of this compensation reflects firm-specific risk, but the other part reflects systemic risk. There is a disconnect, however, between corporate earnings and the movements of the capital markets. Sullivan argues that this disconnect is reflective of a mispricing of risk in the capital markets. This mispricing presents a challenge for portfolio managers, because it implies that at some point there will be a correction. When risk is underpriced, this leads to asset bubbles which in turn will eventually burst. The result of such bursts is a collapse of the market. In principle, to insult a portfolio from this market risk is to eliminate all such pricing distortions, on both the upside and the downside. The portfolio's value would then not be subject to the seemingly irrational fluctuations of the capital markets. Indeed, Sullivan argues that while the global economy has seen a reduction in risk over the course of the last fifty years, capital markets have continued to have high levels of volatility. This is largely because the providers of liquidity capital have an insatiable appetite for returns that causes them to ignore the risks associated with the returns. The investors, then, are irrational and this causes distortions and volatility in the market (ibid).

When firms fail to pay sufficiently close attention to risk, they place their enterprise at risk. The use of measures such as VaR is intended as the first step in avoiding catastrophe at the hands of distorted capital markets and excessive risk-taking. Chincarini (2008) outlines the case of Amaranth Advisors LLC, a hedge fund that was heavily invested in natural gas futures. The firm was subject to considerable market risk in natural gas futures, and when those futures tanked, it brought the company down. This was the 5% catastrophe in action. When investigators deconstructed Amaranth's plays, it was found that the trading environment in natural gas futures in September 2006 was significantly different from previous years, evidence of a 5% catastrophe. Amaranth was not subject to stop limits and concentration limits, so bore the risk of being heavily exposed to positions. The company lost over $4 billion on its natural gas positions from August 30th, 2006 to September 20th of that year. Contributing to the losses is the lack of downside risk that Amaranth's energy traders had, which caused them to essentially "double down" on their positions, increasing their bets knowing that the only change to recover was if the market recovered and they held deeper positions (Chincarini, 2008).

When Amaranth's market risk was calculated for August 30th, 2006, the VaR was $1.33 billion based on the leveraged positions the company held. The company would have lost nearly $3.3 billion had these positions been held. This was four and a half times the maximum loss that would have occurred any other September with these same positions, so it is evident that September 2006 was subject to unusual market movements that caught Amaranth off guard.

The case of Amaranth illustrates that the first step in addressing market risk is understanding the degree to which the firm or portfolio is exposed to market risk. The strategy that Amaranth was pursuing was calculated to be in pursuit of a profit of almost $400 million, but this came at the risk of losing over $2 billion should an unusually bad market occur.

The company's losses were unusual in part because it had failed to understand the market risk to which it was subject. At these high levels of investment, however, liquidity risk was also a factor. With such strong positions, Amaranth was subject to liquidity constraints that accentuated the losses it faced.

One of the interesting areas of study with respect to market risk is highlighted by the Amaranth case. Hedge funds are typically focused on eliminating market risk, but this typically comes at the cost of focused plays that lack diversification. Thus, the firm is swapping a reduction in market risk for an uptick in investment-specific risk. Such strategies also maintain a significant degree of market risk, in particular the market for a specific commodity with which the firm's asset value is going to be highly correlated. For… READ MORE

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