Market Risk – Not to be Ignored or Overlooked

Fund managers, whether they are equity or bond investors, know very well that returns are not just a result of their skill in asset selection. Many external factors come into play. But what are the problems facing professional money managers?

Commodity Trading Advisor, Genuine Trading Solutions of Toronto, found that not all fund managers analyze market risks. The company explains that this is often due to a lack of education and understanding of mitigating solutions to offset risk.

Dwayne Strossen, President of Genuine Trading Solutions, explains market risk as “unexpected financial loss following a market decline due to events beyond your control.” He explains that stock or bond market fluctuations or market reversals can be the result of global events occurring in distant corners of the world. The best analysts and fund managers do not have the resources to look into a crystal ball and predict these events.

Here are a few examples of major unexpected events that sent shockwaves through the financial world:

– 1982 Mexican Peso devaluation;
– 1987 stock market crash known as “Black Monday”;
– 1989 US Savings and Loan Crisis;
– 1998 Russian Ruble devaluation;
– 1998 $125 billion collapse of hedge fund Long Term Capital Management;
– 2006 collapse of the Amaranth Hedge Fund with a loss of $5.85 billion.

In 1994, J.P. Morgan Bank developed a risk measurement model known as Value at Risk or VaR. While VaR is considered the industry standard for risk measurement, it has its drawbacks. VaR can measure the total dollar value of a fund’s risk exposure within a certain confidence level, usually 95% or 99%. What it cannot do is predict when a trigger event will occur or the size of the subsequent fallout. For some companies and funds, a sharp decline or a prolonged recession can be devastating. It could even force some unhedged firms into bankruptcy. A trigger event can have a ripple effect that puts people out of work and drives economies into recession, effectively putting more people out of work. No one and no economy is immune.

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If you own a mutual fund, there is a good chance that your fund is not hedged. Until recently, mutual fund legislation prevented mutual funds from hedging. Many countries have repealed this rule, but mutual fund managers have been slow or decided to continue “business as usual”. This is because most mutual fund investors are uninformed and do not understand the process of hedging, and they may redraw their money from an investment strategy they do not understand.

Hedge funds, on the other hand, do not have these constraints. Investors are more sophisticated and more open to the nature of hedge fund strategies. Some of these are not disclosed for fear of piracy by rival hedge fund managers.

Risk mitigation solutions are not complicated but require the services of a professional who understands the process. This is the role of Commodity Trading Advisor firms such as Genuine Trading Solutions, also known as CTA. President Dwayne Strocen notes that while most CTAs are hedge fund managers, few specialize in risk management analytics. Our focus is on analyzing solutions to reduce or eliminate market and/or operational risk. Regardless of the role, all Commodity Trading Advisors are experts in the derivatives market.

The first step is a value-at-risk calculation to determine a fund’s risk exposure. A risk mitigation strategy known as a hedge is then applied. Ultimately, determining one’s risk is only useful if a solution is put in place to offset that risk. Hedging requires the use of exchange-traded or over-the-counter derivatives. These can take many forms. The most commonly used hedging instruments are index futures, interest rate futures, foreign exchange, exchange-traded commodities such as Crude Oil, options, and SWAPs.

A more detailed explanation of derivatives and hedging will be covered in our next article. Now that we have identified an easy solution for your market risk concerns, implementing the right strategy can be as easy as calling a qualified and registered Commodity Trading Advisor.