Risk (management) shocks
The risk management rules of most institutional investors follow widely accepted standards. Yet, similar rules often coerce similar flows. And one-sided flows in markets with limited liquidity can push prices far from fundamental values. In this way, conventional risk management rules can be a cause of distortions and even set in motion self-reinforcing feedback loops.
Prominent concepts for risk management are value-at-risk (VaR), a statistical measure of expected maximum losses at a specific horizon within a specific confidence interval and expected loss, a measure of expected drawdown in a distress case. These statistical assessments of risk rely on historical variances and covariances, and can be subject to sudden major revisions.
- The half-time of many VaR measures is no more than 11 days, making them subject to sudden drastic re-assessments.
- Even risk measures that rely on longer historical simulations have only limited data on actual crises and hence are very vulnerable to changes in assumptions and new crisis experiences (view post here).
- Different types of statistical risk models tend to diverge during market turmoil and hence become themselves a source of fears and confusion (view post here).
Reliance on statistical metrics can give rise to so-called ‘VaR shocks’: If the estimate of the risk metric-surges, VaR-sensitive institutions automatically recalibrate the risk of their existing positions and subsequently have to reduce their holdings of assets (view post here). Put simply, if an institution has a fixed risk budget a doubling of the estimated value-at-risk or expected loss requires it to liquidate half of its nominal positions.
Analogously, many trading desks or asset managers set “drawdown limits”. These are loss thresholds for a portfolio’s net asset value beyond which traders must liquidate part of all of their positions. Managers are typically under obligation to cut risk regardless of asset value and return prospects. Hence, once the common drawdown limits are broken additional flows ensue in the same direction of the original loss, accentuating price movements for no fundamental reason.