Market risk is the risk that the value of a tradable asset will lose
in value due to market factors. For instance, stocks can drop or rise in
value, interest rates can change, affecting the prices of
bonds. Market risk is not very subtle - one can usually see in
real-time how much money is made or lost. It is likely the first thing to
come to a person's mind when he is quizzed about the risks of investing.
Because it is so obvious and ubiquitous, a lot of time and effort has
been spent to model, understand and contain market risk. The subject is far
too large to cover in one node. In order to give a good example of how to
measure market risk, the Sharpe Ratio will be presented. I will then
discuss some techniques to hedge it.
The Sharpe ratio is in essence a measure of the return we get divided by the risk we need to take for this.
Here, risk usually means market risk.
Let us start with the
definition of return
. We note that there exist
certain risk-free investments
, most notably
in a credit-worthy government. Now, in essence, anyone
can get this type of return without taking any risk, so this return is the
. The excess return is the expected return on the investment, say
6%, minus the return on a risk-free investment, say 2%. Hence, the excess
return in this example is 4%
The risk can be measured by estimating the standard deviation of the
historical returns. Of course, this assumes our estimated return is
approximately normally distributed and that our
historical returns are a good estimate for the future returns. Let's assume
our hypothetical asset has around 10% annual fluctuations in return. This
would put the Share ratio at around 0.4. Ref. 1 suggests this is a pretty
normal Sharpe ratio. It also means that when investing around 3 years, we
have a pretty good chance of being up.
In the discussion on risk, I've already mentioned there are some
assumptions made in computing the Share partio. These assumptions are
usually false. This makes the Sharpe ratio is a pretty crude tool to
measure the risk/return. However, it can be useful in attempting to minimize
market risk. By investing in products with a good Sharpe ratio, we can get
more return with less risk, at least, in theory.
Minimizing market risk
There are a few common techniques to minimize market risk. I'll sum up a few
of them here.
- Diversification: Perhaps the most old-fashioned way of minimizing
risks, the theory is that your risk becomes smaller as you spread your money
over multiple assets classes. Statistically, this is true - if you split
your money over, say, 10 different stocks instead of 1, your fluctuations
are expected to be less - by a factor of sqrt 10, to be exact, if all stocks
have the same volatility and no correlation. In pratice, stocks are usually
correlated, so the risk reduction is a lot less than that factor.
Furthermore, this tends to work reasonably well until the shit really hits
the fan, because in such cases, everything tends to go down together.
- Market-neutral portfolio: This one is popular with hedge fund. Imagine we think that, say, oil stocks will outperform. We
can then go long oil stocks and go short the index as a hedge. This
way, I'm hedged when the whole market crashes. This puts a lot of faith in
my initial assessment that oil stocks will go up: if I'm wrong, the
long-term tendency of stocks to trend up won't help me.
- Option strategies: Options can be used to create as
interesting a risk profile as you want, with corresponding returns. This
also means there are many interesting ways to blow up. Nonetheless, buying
a crash put under a portfolio, perhaps compensated by selling
calls, is a popular if a bit expensive way of hedging against the
worst market tantrums.
Given the techniques above, market risk can be taken in exactly the way
a market participant wants to have it. This means that smart investors can
easily make sure they don't take more market risk than they want to bear.
This makes market risk a risk that is, in practice, normally not extremely
dangerous, no matter how painful a stock market crash might look. In
practice, the much more difficult to predict but potentially far more
devastating liquidity risk and counterparty risk should never be
underestimated. As an example, losing 10% on your structured product
because the market crashes is one thing. Losing the other 90% because it was
guaranteed by Lehman Brothers is far, far worse, especially if you needed