The New Age of Risk Management

The last decade of the twentieth century augured in the Age of Risk Awareness. In the financial markets, investors are faced with increasingly diverse and complex investment alternatives that can be used to achieve exceptional performance. In the past ten years, we have witnessed an explosion in investment opportunities in new instruments, strategies, markets and asset classes. Market makers of these opportunities have the double responsibility of creating the benefits of these products and, at the same time, hedge the firm's exposure to the factors that drive performance of these products.

At the same time, recent, highly publicized breakdowns in the financial markets have heightened awareness of the need for market risk measurement and management. We have all witnessed in the past few years the news of spectacular losses attributed to derivatives and complex trading strategies. These losses have spawned a flurry of legislative activity into the regulation of the financial markets, as well as a new industry of information technology specialists who build and market risk management systems.

Although derivatives are particularly effective tools for risk transference and speculation, they can lead to large losses if used inappropriately. The above chart, prepared by Capital Market Risk Advisors, Inc., shows the sum of losses publicly attributed to derivatives from 1987 to 1995. These losses grew sharply in 1994 due to interest rate fluctuations, which created volatility in bond markets. From 1987 to 1995, these losses totaled $16.7 billion.

An interesting question is how significant are these losses? In relation to the total notional size of the derivatives market, $50 trillion, they represent only 0.03%, which is quite small in relative terms. It is the suddenness of these losses that make derivatives seem dangerous. Recently, the losses experienced by firms such as Long Term Capital Management indicate that the potential for large losses with global implications is possible.

As a result, a few managers, directors, and trustees have taken the extreme step of eliminating all derivatives from their portfolios. The irony of this is that, in some cases, these activities may have actually increased their risk. When utilized appropriately, certain derivative instruments can be a cost-effective method for mitigating or managing portfolio risks.

All participants in the global financial markets are faced with an entire constellation of risks. The following table illustrates many of these risks.

In the Age of Risk Awareness, the approach taken is to quantify, in economic terms, the above risks. For example, in the case of market risk, one would measure the expected economic loss due to adverse price movements in financial instruments. Value at Risk is a specific quantitative methodology for measuring market risk.

Value at Risk quantifies a predicted maximum loss (or worst loss) over a target horizon or holding period within a given confidence interval. This means that in order to derive VaR we will be applying some probability and statistics using asset pricing models, large financial databases and market data feeds.

The market risks that financial intermediaries reallocate are price, interest rate and currency exchange rate risks. Price and rate risks come in a variety of flavors, but all markets share two features: 1. Any movement in a price or rate will be undesirable to some market participants. The popular name for exposure to an undesirable market movement is market risk. 2. One person's risk is usually someone else's potential reward. By exchanging packages of risk and rewards, both parties to a risk management transaction can be better off.

To draw an illustration from a typical price risk environment, let us look at a new issue of common stock from the viewpoints of three key market participants:

• The corporate issuer that sells the new stock into the market place
• The asset manager or investor who buys the stock on the initial offering or as a seasoned offer, and
• The market-maker who trades the stock in the secondary market as the needs of asset managers and investors change over time.

The figure below illustrates each market participants' notion of risk. Each is exposed to financial loss - accounting or opportunity loss - but each views the possibility of loss from a different perspective. And, each has a different notion of what Value at Risk is.

If we begin by examining market risk with the market-maker, we find a classic risk position. She is exposed to any large price change. Nothing could make her happier than a regular alternation of buyers who take her offer and sellers who hit her bid. However, by posting a continuous bid and offer, the market-maker exposes herself to potential loss if the stock price moves very far in either direction. If the market falls, the market-maker will be called upon to buy more stocks, and her inventory will decline in value. If the price of the stock rises, the market-maker will be called upon to deplete her inventory stock. With a reduced inventory, the market-maker's participation in the rally will be limited. She might even sell stock short to meet market demand. As a short-seller, the market-maker will face out-of-pocket losses in a market advance. The market-maker's position is disadvantageous - risky - if prices fall or rise sharply. The market-maker has a two-sided Value at Risk, an upside risk and a downside risk.

Let's look at the stock issuer's perspective on risk. The issuing corporation views risk as exposure to a rising market. If the corporation had waited to issue the stock until after the market rise, it could have obtained the same amount of cash for newer shares. For the issuer, risk is a stock price that rises after it sells stock. If the stock prices the day after the shares are issued, the issuer's sale of the stock today will appear fortuitous. The issuer faces as Value at Risk the spread or underwriting discount (i.e., the difference between the price the issue receives and the price offered to the public) or underpricing (i.e., for IPOs, the fact that stock prices rise substantially after the issue date). The corporation's Value at Risk as an issuer is upside risk.

The asset manager or investor who buys stock as a portfolio investment sees risk as the possibility of a stock price decline. If the prices drop tomorrow, the investor will wish she had waited to buy. Of course, a stock price that rises after purchase is a favorable development for the investor. The investor or asset manager when thinking about Value at Risk is really focusing on price decline.

As you can see from this example, each type of market participant has a different notion of Value at Risk measured over different time horizons and possibly different confidence levels. The risk measurement and management systems used need to reflect the participant and the intended applications.

Frederick Novomestky, Ph.D. is director of the Financial Engineering Program in the Department of Management at Polytechnic University. He can be reached at [email protected].