Risks - Budge? - Try Hedge |
The introduction of trading in Index Futures in the Indian markets will now enable operators, both individuals and institutional to hedge risks. Trading in financially engineered products such as futures, whose value is derived from the underlying asset - in this case the scrips on the index, will help operators to cover their positions into the future. The risk characteristics of emerging markets differ from those of more mature markets in fundamental ways. Even standard concepts such as hedge ratios or statistical measures such as correlation and volatility must be suitably interpreted before being applied. In addition, the relationships between these risk measures can undergo abrupt and dramatic changes, similar to the phenomenon of a "phase transition" in physics. The new risk regime which involves hedging trades can turn out to have quite the opposite effect and actually increase the risk of the position if one does not comprehend the concept and the nature of the derivative instruments. In order to manage risk effectively it is essential to move beyond the ordinary calculus of risk sensitivities and consider the effect of such a transition on one's portfolio. This article illustrates how portfolio transitions can be done in order to hedge risk and cover positions.
Managing Market Exposure in illiquid Markets
The estimation of statistical parameters such as volatility requires a time series of market data. This can be particularly troublesome in markets in which the underlying stock experiences only sporadic bursts of trading volume and although techniques have been developed to account for this, the net result is that a lack of liquidity reduces confidence in forecasting volatility. A general rule of thumb is that, for a short options position, when you most need to rehedge, the volatility will exceed your forecast. There is a common sense explanation to this: rehedging an illiquid stock will cause a greater market movement than for a corresponding liquid stock since it increases selling or buying pressure which in turn results in a greater movement in the stock price, and hence greater volatility.
The above aspect leads to a risk management paradox, which is illustrated by the narration of an incident below. A certain trader had a short options position on an illiquid stock. Because its price had recently dropped, he found himself with a net long position in the underlying stock. The risk manager dropped by and told him to "hedge it up" by the day's end. The trader tried to explain that the act of attempting to rehedge at that particular time would only drive the stock price down more and make matters worse, but the risk manager was unmoved. What did the trader do? He actually purchased more stock, which quickly drove the stock price up so much that his net exposure dropped to zero.
In the new risk regime what were intended as hedging trades can turn out to have quite the opposite effect, and actually increase the risk of the position.
The root of the difficulty here is that the very calculation of exposure in this case requires an assumption concerning the current stock price (not to mention also a forecast of volatility). For an illiquid stock the "current" stock price is really the expected transaction price, which depends upon whether one is a buyer or a seller, as well as the proposed size of the transaction. These issues are present as well for a liquid stock, only to a lesser extent. Of course during a general market disruption, all stocks become less liquid and so in that sense this principle generally applies. Hence It becomes imperative to augment one’s risk profile by considering the effect of alternative risk scenarios and the positions that one is in.Deepak V Kuriakose