MARKET FEARS DICTATE WIDE RISK TOLERANCES

Early 2015 proved FX pairs can move up to 30% in matter of minutes when CHF caught market of guard. In 2016 British Pound Sterling showed fast and big movements on more than one occasion. In portfolio risk management this translates into a necessity to run unaggressive risk settings. But what’s left on the table for investors that want to play it safe?

 

3% SPREADS IN STERLING

GBP flash crash moved the price of Sterling by 10% within a couple of minutes. More importantly spreads were recorded in the 3% neighborhood. Because it was an overnight move portfolio risk manager with longer than intraday positions must take into account the possibility for positions to suddenly move deeply into red.

So far these wide spreads have been isolated to one particular currency. Nevertheless, global development does not rule out spread widening events of broader scope where multiple currencies could show more than 3% spreads simultaneously.

 

BREXIT, ECONOMIC READINGS, GEOPOLITICAL TENSIONS

If Brexit fears are enough to move the market to 3% spreads, then we need to ask ourselves what a worldwide financial event feared by BIS could do to the market for example. Key takeaway is that price risk could remain greatly elevated for months or even years to come.

This forces a lot of market participants to pursue intraday trading using very tight stops. Fewer and fewer are willing to trade through news releases and so more traders are focusing on trading during specific timeframes during the day, which is when shocks are not expected. Nevertheless, a big event could be triggered at any time of the day. If specific combination of factors occurs, market can crumble suddenly under a mountain of stop loss orders. This can come in form of geopolitical event in combination with economic event alongside the before mentioned tactical event in the markets.

 

PRICE RISK vs. SPREAD RISK

Regardless of the trigger probably the safest prediction to make would be that prices in the disturbed market could fluctuate by more than 30% perhaps during 24 hour period. Running price risk therefore is not recommended and is highly speculative in these days. Even long term conservatives could be stopped within minutes. That is unless in your portfolio risk management the target is risk free rate.

On the other hand, if 2008 is any indication, then spread risk is more efficient approach. During 2008 crash prices moved by 40% quickly in a lot of FX pairs, but spreads did not increase beyond what we have seen in GBP recently for example.

 

NUCLEAR SCENARIO

The biggest question contemplated among largest institutional investors and professional portfolio risk managers in current era is how much spreads could widen in an event of a nuclear military conflict. The assumption is that capital market would at least attempt to digest the event and continue with matching operations.

Laws of finance predict that market could sustain itself and actually perform its own job even if it experienced 5%, 6%, 8% or even briefly more than 10% spreads on major currencies. If we imagine 10% spreads simultaneously on all major currencies, such scenarios seems brutal, however it is a quite possible event.

 

IONECTAR PORTFOLIO RISK MANAGEMENT

ioNectar technology predicts market can remain operational in such an environment. Competitiveness of capital will not be diminished and velocity of money can become surprisingly high during such times. That means also that opportunities can be abundant during such events as well. Even under very strict risk arguments, when this happens the yield investors can achieve can still satisfy investment targets.  During 2008 crash risk free rate spiked beyond 30% p.a. for example.

Naturally, we are not focused on expecting a nuclear event. However, we should not treat such topics as taboo. Despite all, sometimes portfolio risk management is about being prepared for rare extreme scenarios that ultimately perhaps never happen at all. Spread risk is a more robust approach to investment process during such times when uncertainty runs high.

Professional portfolio risk manager understands that spread risk together with appropriately prioritized distribution by time horizon is necessary for black swan event proven approach. When properly configured only the necessary portion of risk is lost on spot, while the long term risk float remains protected and still working actively in the market, taking opportunities for what they are worth.

Gregor Kozelj
Gregor

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