 Hi everyone, it's MJ and in this video I want to talk about how to manage market risk now essentially there is this one idea that okay If you've got market risk You simply transfer a portion that you're uncomfortable with holding using a derivative or you can Reduce a portion with with hedging But it's important that when we look at these two standard approaches to measuring market risk that we understand a little bit of their drawbacks. The first thing is that When we transfer a portion or reduce a portion with hedging or derivatives We're losing upside as well even with the call option by paying for that premium You're sacrificing some of your upside potential Also important to know that derivatives They can get quite nasty. They can get very confusing and because of this They become complicated and there's now an operational risk of making mistakes Also, what I think students don't necessarily understand is that we have this thing called basis risk And this basis risk is the idea that sometimes the right instrument that we're looking for the right strategy that we want to play Doesn't exist on the market. If you've got some strange asset like oh, I'll just transfer it with a call or a put option Well, hold on maybe that's not actually going to be on the market and this tends to happen Let's say if you're trading and say Africa and you're buying some African stocks You're not gonna have the array of derivatives that you do whether you're investing and say in America on You know the standard and poor looking at the top 500 companies there So that's also something to appreciate with managing market risk is basis risk Sometimes you have to use a different strategy. That's not actually perfect and that's gonna leave you still exposed Then derivatives are not a sure thing There is this counterparty risk There is this probability that the other party is unable to pay and in that movie the big short That was that whole discussion that they were having towards the end where the team were really convincing their manager to say Close out the positions close out the positions and he's saying no every day I wait they're gonna get bigger and bigger and bigger and they said yes The payoff might get bigger and bigger and bigger, but they're getting so large that we're actually incurring counterparty risk There's a probability that these banks themselves could fail and take down all the derivatives with them Think about Lehman Brothers Bear Stearns when they failed those derivatives weren't fully paid out They needed to bail out and it was a very complicated thing So very important to understand the limitations of the two more popular Managing market risk strategies sometimes the exam will even say to you How do you deal with this market risk if you can't transfer and you can't use hedging? And that's what we're gonna come and talk about in this video The one thing we can do and this is very much when it comes to managing risk link it up with the dimensions of risk You can see how each dimension you can control the uncertainty So for instance the one thing you can do is you can reduce the risk duration by either selling earlier or Entering into a shorter period contract. So you can use swaps to Change the the duration and not necessarily just you know the payoff or the severity You can also use these derivatives to help you with with your duration But you can also just sell stocks if you want to get rid of market risk instead of holding them for a year You can hold them for six months. You've effectively reduced the duration Of course, we want market risk because it tends to pay out in the long run So sometimes we might look at ways to increase duration then there's another way of Reducing frequency and if you're worried about oh, you know I'm gonna buying shares the price is constantly fluctuating and you know, how's this gonna affect my solvency ratio then One strategy might be to say well instead of buying shares on the public stock exchange I'm gonna rather gonna buy them privately so other private equity private debt Private property and by not buying it on the market. There's not gonna be this constant Evaluations that might threaten my solvency ratio But it is important that if you do do that method You are gonna lose a little bit of market ability because it is harder to sell things privately Then it is to sell them on a public market And this is also an idea that I want to put forward to everyone is that whenever you manage a risk There's a residual is either a residual risk or there's a cost to doing it So you do get rewarded for taking on risk and by managing risks You are going to incur a little bit of a penalty But in the exam it's important that you're able to come up with all these different ideas as well as highlight the drawbacks of each of them Now we can also reduce Severely by buying assets that have traditionally had a low volatility Although the drawback here is just because something had a low volatility in the past doesn't mean it's gonna continuously have a low volatility in the future This is something that we're finding out with say the corona and the pandemic It's a lot of shares that were very stable have suddenly become very very crazy But in normal market conditions, you can maybe get away with saying well It's less riskier to buy a share with a very low volatility Then one that has had a very high volatility in the previous year because they do tend to Follow a little bit of a change unless like I say with the corona virus. It's been a systemic shock It's a natural disaster It's a world emergency. So of course that is going to make things a lot crazier Managing market risk. Another common idea is to use diversification. Sometimes this is even In part of that these ones over here. It's like one of the main things people say is like, oh, just use diversification Long-term capital management, they were famous for getting like 40% returns and all of these things And they didn't want to like market They didn't want to manage their market risk because of you know fear of losing the upside So they thought that they could get away with managing market risk simply by using diversification buying a whole bunch of different assets Now the idea here is that if Correlation is low it is going to reduce severity However, when the market starts to panic Correlations increase. This is why we now use copulas. What happened with long-term capital? Russia defaulted on their bonds, which they didn't think they were going to do the Thai currency became incredibly unstable There was a lot of panic in the mid 90s and it kind of wiped out their positions because they didn't have the liquidity To keep topping up their margin calls because they were using leverage because they they were so sure of their trading strategy And they thought diversification was going to help them get through all the pain and it didn't so it's a good good case study Is to look at long-term capital management and how simply using diversification can fail you So also know that there are the drawbacks of diversification Another thing that you can talk about with diversification which often isn't mentioned is that When it comes to buying and selling investments and assets, you need a lot of specialties like if you're buying shares You need to know what those companies are doing. You need to have a little bit of fundamental knowledge Now if you start diversifying so you start not just buying say You know Apple and Amazon and Facebook and the tech stocks But you also start buying Boeing and a few of the other, you know, airline things Then you need that additional information in order to understand those markets So if you're a single team or if you're a small team Diversification might not necessarily be possible. So in order to enact diversification properly You might need to hire additional staff hiring more staff is going to add to expenses It's going to increase operational risk. You have to provide more oversight So diversification once again is not the silver bullet that it's made out to be Specifically in the earlier actuarial subjects. So what it's a very very important thing to understand or the limitations of diversification Then this last one is is interesting is What we can also do is we can reduce the required capital okay through leveraging But this is interesting because what we're doing is we're reducing one risk dimension But we're going to increase another risk dimension. So by reducing the amount of capital you need You're going to increase your severity and again This is what long-term capital management We're doing is they said well We're quite happy to take on severity because if market risk over the long term has got a positive trend Then yeah, let's do that Let's reduce the amount of capital we need in order to capture more more gains And it worked well for them for the first two years like I said 40% return But when the crazy market came and there was panic and there was extreme volatilities They had to close out their positions because they didn't have enough capital and what they were doing is they were leveraging and One of the things that you can do today is you can enter into something called a CFD or a contract for difference Where essentially you don't buy the share because you want to be an owner and enjoy the returns of it for the long term Instead you're like I think the shares gonna go up 10% in the next week Instead of being an owner. I'm gonna effectively place a bet. It's a gamble It's a speculative instrument that says if it goes up 10 10 percent I want to pay out of times 100 of course if it goes down 10 percent I'm gonna pay out times 100 and that could absolutely wipe out my margin call But it does allow you to get more exposure while requiring less capital So these are the different or alternative ways of managing Market risk and the trick here is to look at each dimension of the risk and say, okay How can I control the uncertainty within each of these dimensions and that in a nutshell is Managing market risk