Always expect the unexpected

Holy Cow! Over the past 15 months we have seen remarkable events in the medical field, in nature, politics, sports and the trading markets. The headliners include Covid-19, vaccine development, brush fires, freezing temperatures in warm climates, warm temperatures in freezing climates, political and social unrest around the globe, impeachment proceedings, senior Royals stepping down, the cancelling of the Olympics, the death of Kobe Bryant, a stock market crash and rebound, negative commodity prices in Crude Oil and a powerful stock squeeze. So many unpredictable events impacting our lives and our mental states and how we will perceive the future. Not even the finest ‘Magic 8 Ball’ device could have forecasted these events.

There have always been, and will continue to be, unforeseen events that impact our behavior. However, we have no control over who, what, where, when and how these events appear. The same goes for the market; the risk that never leaves us is the unknown. The market listened and reacted to all the events listed above, but in differing magnitudes and intensities. Whether the reactions were rational/irrational, too big/too small, handled properly/poorly will be debated for a long time. The only certainty is that market reactions to newsworthy events will continue.

Managing the ‘event risk’ of known events like economic announcements, elections, crop reports, and energy supply data is a skill learned by looking at historical outcomes and outliers from prior announcements. Having industry experience in a particular sector is a great bonus. Applying market and correlation shocks that mirror past performance is a standard starting point for known events. In many cases, once the known event has passed, much of the uncertainty driving market behavior is temporarily removed and volatility is reduced. However, evaluating and managing the risks of unknown events involves some creativity. It is an art as much as it is science.

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Two Scenarios (A and B) of unanticipated events and two different risk methodologies:

Short Term Spike Scenario

The takeaways: Violent Spike, Short-Term Impact and Certainty

A) The cold weather event in the Southern USA in February caught many people off guard. Electricity prices skyrocketed as temperatures dropped, demand rose exponentially, and the electricity grid became unstable. This created tremendous short-term uncertainty. But as unexpected and unfortunate as this was, this cold temperature pattern was not going to continue indefinitely. Weather forecasters pinpointed a return to normalcy relatively quickly.

Managing the risk to define the effects of this type of event involves applying extreme shocks to spot and front month prices (and related option volatilities and skews) while essentially leaving back month prices and volatilities static. It is wise to stress Implied option volatilities by a large multiple (2 to 5 times for example) of their current levels to expose ‘short-teeny’ risk (a position that is short out-of-the-money options). The weather event described is a ‘one and done’ occurrence and the practice of creating ‘front month’ price and volatility shock correlations for deliverable commodities should be a standard part of every risk manager’s tool kit. Even if the event you are trying to simulate/anticipate does not materialize for months or even years, it is critical to have the information available daily and assess the materiality of the outcome across an entire organization.

Long Term Uncertainty Scenario

The takeaways: Uncertainty, Safe vs. Risky and Breakdowns of ‘Normal’ Correlations

B) Using the Covid-19 pandemic as an example, most alive today never lived through a global pandemic. How long will it last? How contagious is it? Who is most at risk? Is there a cure? The emergence of Covid-19 as a global pandemic was slow and steady. There was conflicting information in the medical community about the cause and severity. Financial markets do not like uncertainty and as such, equity prices plummeted in March 2020 as the World Health Organization (WHO) announced a global emergency. Many countries followed the WHO announcement with travel bans put in place to stop the spread of the virus between countries. With tight restrictions in place for daily activities, industries like airlines, hospitality, entertainment, restaurant, energy, automotive, manufacturing and sports were all hit very hard. Unlike the weather example above, the was no clear guidance on how long we would be dealing with this issue (it is ongoing today). Unlike the “one and done” weather example above, the Covid-19 event has financial implications over a much longer term. How does a risk manager prepare for an event for which we have no reference data? We will explain potential scenarios to have at the ready.

Managing the risk to anticipate a scenario where industries and societies are slowed indefinitely demands some creative thinking. Some assumptions may assist in our process. Governments around the world will most likely seek to lessen the impacts of the event by providing liquidity (i.e., lower interest rates). Investors will look for some certainty by moving from riskier assets to less risky instruments (think of a ‘flight to quality’ toward government bonds, gold and silver and away from stocks for example). The yield or growth on investments will be less important than preservation of capital. ‘Safe’ assets will appreciate, and ‘risky’ instruments will depreciate. ‘Normal’ or ‘historical’ correlations across the yield curve and futures price curves breakdown. Unlike the weather example, the asset price movements affect tradeable assets 1 year, 2 years and even 3+ years into the future as there is no clear end to the societal disruption. Stock sectors like energy, transportation will suffer as daily demand for travel and daily commuting is reduced, while sectors providing services to help remedy the situation will expand.

A stress scenario that will provide a view into potential outcomes for this type of event applies equivalent price/yield movements (the same percentage or absolute price/yield shock across every expiration month of a product) to simulate real world market reaction. For example, applying the same basis point shock to all interest rate instruments on the yield curve will give a view into the P&L implications of a ‘flight to quality’. This estimate will not be perfect, but it will expose strengths or weaknesses of positions. Similarly, using the same absolute price shock and volatility change to all gold contract expirations is a starting point. On the negative price side, all stock sectors can be shocked by the same percentage move regardless of country, sector or market cap.

Shocking all months of Crude Oil or Copper in the same magnitude will expose weaknesses that would not appear under standard correlated stressing scenarios. For option positions, shocking the skew (the relationship between put and call volatilities) and the At-the-Money volatility in the same manner across multiple product expirations exposes the risk of a change in market sentiment. Products that traditionally had ‘bullish’ skew prior to the long-term disruption may now have a completely ‘bearish’ skew (and vice-versa). The P&L and Greeks associated with this change can be enormous. Adding the calculation of ‘extreme’ price and volatility shocks is also a necessary tool in the event of a ‘once in a lifetime’ occurrence (shocking prices by 10 -15 Sdev moves, whoa!.. but think about the explosive movement of Crypto Currencies and Game Stop stock over the past 15 months!)

Creating market stress scenarios to address the situations above should be normal operating procedure to identify weaknesses in trading positions. The goal is to expose risks not seen when using only current or historical price moves and correlations. While none of us has a crystal ball to predict future events, being prepared and having advance knowledge of potential financial outcomes prior to an unscheduled event is the key. The creative use of combinations of price curve stress, correlation breakdowns and volatility shocks allow a risk manager to “always expect the unexpected”.

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