Critical Evaluation
Chincarini's analysis of the Amaranth collapse contains five key lessons for portfolio managers and regulators with respect to managing market risk. Of the ones applicable to firms, the first is that liquidity risk must be accounted for. Liquidity risk in Amaranth's case compounded an already-bad situation. The second recommendation is that liquidity risk measures should be developed that are common -- the way that VaR is common -- so that communication of liquidity risk is consistent throughout the firm and throughout the industry.
The third is that internal risk management practices must be upheld. The best strategies for managing market risk are irrelevant if the firm is not in a position to implement them. In the case of Amaranth, the energy traders were in Calgary while the risk managers were in New York. This made it more difficult to control the firm's exposure in the natural gas futures market. As well internal incentives should reflect the firm's outlook with respect to risk management. Often, successful trading strategies are handsomely rewarded, while those same players are subject to limited downside risk.
When the nature of capital market distortions is analyzed, irrational behavior appears to be present as evidenced by the disconnect between real world market performance and capital market volatility. This irrational behavior may result from situations such as that at Amaranth, where the risk-return tradeoff for the energy traders was not in line with the actual risk-return tradeoff in the market. That the traders increased their bets in the face of steep losses is evidence that such distortions can not only increase the disconnect between the markets and reality but can severely distort risk and return for the company. If market risk is successfully managed, the firm should not be subject to these distortions, so the incentive programs should reflect rational expectations of risk and return on an enterprise-wide level. The last lesson is that spread positions are not arbitrage positions, and must therefore by factored into any evaluation of market risk.
Of these insights, the only one that addresses the issue of market risk on a systemic level is the call for a common measure of liquidity risk. The remainder are largely focused on managing risk at the firm-specific level -- other companies did not suffer the same fate as Amaranth because they did not have the same trading strategies and risk management style. Some of those same strategies were designed to address market risk, at least under normal circumstances, but were misused by Amaranth. As a hedge fun, Amaranth was not expressly intending to eliminate market risk, however. But hedge funds do provide an opportunity to study the issue of market risk further, because many are designed to perform with negative betas, acting as a counter to market movements.
What the Amaranth case highlights is that the same strategies utilized to counter market risk can increase a portfolio's level of firm-specific risk. Amaranth's energy desk was focused on specific natural gas futures plays, a portfolio that can be described as decidedly lacking in diversification. Yet, such a portfolio could have a role to play in countering market risk. If the concept of diversification is applied beyond the stock markets, greater diversification of investment types and investment strategies could result in a portfolio being hedged against stock market risk, if not total market risk. Commodities, currencies, real estate and other tangible goods, emerging markets, fixed income, hedge funds and other investments when put together can reduce a portfolio's total volatility vs. The market, especially when it is considered that some elements often move opposite the market.
Blankfein (no date) argues this point, claiming that market risk is subject to the same principles of quantification as other forms of risk. He outlines a number of different models that can be used to understand market risk. The exponentially weighted moving average model is useful because it measures volatility against the total market while taking into account the reality that high volatility days occur in clusters. This helps account for those 5% incidents with abnormal returns, the same 5% events that threaten firms that lack adequate insulation from market risk. Building on this model is the GARCH3 model, which assumes that variance rates are mean reverting, trending towards a long-run average. These models are used to help firms understand the rate of market risk to which they are subject.
Black-Scholes has also proven applicable to the analysis of market risk. At the heart of Black-Scholes is the concept of a...
For derivatives, of course, risk is associated with both expectations of future movements and with time. The risk neutral price of a derivative, as derived from Black-Scholes, is the price at which that derivative should be traded. When applied to the concept of market risk, the risk neutral portfolio is that to which the firm or portfolio manager should strive. The estimates of market expectations are difficult to discern when managing a portfolio consisting of a wide range of investments, but this underlying principle would allow the firm to understand its risk position.
Using Black-Scholes is complex, and may not be practical in all circumstances. Firms therefore gravitate towards simpler measures such as VaR. The VaR can be calculated in one of four ways, but all should deliver the same result (Russon, 2008). A VaR of zero would be perfectly correlated with a lack of market risk altogether, but this is not the objective of portfolio managers; a lack of market risk is a real return-protected Treasury bill. This highlights a key practical difference between market risk and firm-specific risk. While portfolio managers often attempt to eliminate all firm-specific risk from their portfolios, they only seek to manage market risk.
Whatever method is chosen to understand the firm's level of market risk, the policy prescriptions for managing that risk are highly dependent on the firm. Hedge funds typically seek to earn returns that lack market risk, but to do so they take on substantial firm-specific risk. The broad market may not affect their strategies, but their strategies often lack diversification. For other portfolio managers, the most important consideration is the 5% of the time that the market does not behave within the bounds of expectations. The firm could in these circumstances potentially lose more value than what is considered to be "at risk" in the VaR calculation. At this point, stress testing is the most common means by which market risk is assessed. The manager seeks to determine how much is truly at risk if market movements are abnormal. Perhaps at this point an adaptation of the concept of volatility clustering should be implemented, as it would prove valuable when stress testing to analyze impacts over clusters of abnormal negative impact days.
Conclusions
Market risk is difficult to hedge, and no perfect hedge is likely to occur. Unlike firm-specific risk, market risk should almost always exist. Thus, the management of market risk is based around understanding the market risk faced by the firm, stress testing this risk and making adjustments to the portfolio to adjust this risk level, should the risk level be found to be unsatisfactory. A number of methods have been identified as critical to managing market risk, including closer connection between traders and the firm's risk managers, and developing better measures of liquidity risk. The field of market risk management is still in development, however, and there are no accepted techniques for managing this risk; even the measures are just being developed at this point in time. Because of that, portfolio managers should focus on understanding their levels of market risk and implement strategies to control that risk level.
At the practical level, firms can begin to manage their market risk simply by measuring and addressing this risk. Market risk disasters often occur because firms either do not understand that they can manage market risk, or because they are ill-equipped, with inadequate measures, to understand the market risks faced by their firm. Diversification opportunities -- by investing in other markets either in terms of geography or commodity -- exist and firms can take advantage of them, but may lack incentive to do so if the risk managers do not understand the risks the portfolio faces.
