Thursday, May 21, 2015

VaR-shocks - a positive feedback loop problem

There are supply and demand shocks that can disrupt markets as well as VaR-shocks which may be every bit as painful for money managers. The manager who runs his risk management based on VaR looks at an amount of loss for a given probability for a set time period as a target for maximum risk exposure. The VaR is a function of three things, the size of the positions, the volatility in the markets, and the correlations across markets.

The VaR is the threshold at which there will be an automatic sell-off of exposure so as to reduce portfolio volatility. The VaR will be the market-to market loss over a fixed horizon given a known distribution. If VaR for a hedge fund is kept constant, a lower market volatility will lead to bigger positions. If the volatility or correlations of the markets increase, then to keep VaR constant there will have to be a decrease in positions. Hence, a longer-term low volatility environment will have more risk-taking. But, if volatility starts to increase positions have to be exited.

When there is a low volatility environment, firms may increase position exposure through the use of higher leverage.  In cases like these, small changes in volatility can cause a cascade of deleveraging based on VaR levels being breached.  It can easily be argued that a VaR-shock could be worse than a supply or demand shock because the spillover across markets can be more significant. Position risk has to be reduced and the cuts may come in unexpected places. 

A VaR shock can create a positive feedback loop. The attempt to maintain the VaR level may mean further volatility increases will translate into further positioning cutting - the dreaded feedback loop. Once selling starts it can continue as more markets  are caught in the sell-off.  This is one of the reasons why there should be a so much focus on the current European bond market sell-off. 

VaR shocks are hard to manage not because we don't understand the risk principles involved but we don't know the reaction to shock. For example, trend-followers love trends, but a VaR shock may start   generate price moves in markets that are totally unexpected. Existing trends are reversed. This was the scourge of the risk-on/risk-off period. For banks which deal almost entirely in the debt markets, a VaR shock in bonds is an especially difficult problem. Illiquid assets cannot be sold so the focus gas to be on the most liquid bonds which are also benchmarks. This is a feedback loop that spill-overs across the entire macro-economy. 

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