1/ Recent market activity -- and the short-vol trade in particular -- provides a fascinating, close-up look at "wrong-way risk."
Wrong-way risks are positive feedback loops that can have tragic effects on a portfolio.
So tonight: wrong-way risk with 🏠 & ⛈️!
Wrong-way risks are positive feedback loops that can have tragic effects on a portfolio.
So tonight: wrong-way risk with 🏠 & ⛈️!
2/ Say you own a 🏠 in Florida, and you buy ⛈️ insurance from a company that specializes in natural disasters.
You're all set, right?
Now consider: what if that company, despite -- or possibly because of -- their expertise, became overexposed to Florida properties?
You're all set, right?
Now consider: what if that company, despite -- or possibly because of -- their expertise, became overexposed to Florida properties?
3/ A large hurricane could overwhelm the insurance company with claims, bankrupting them and rendering your insurance worthless.
So you thought you hedged your risk, but it turned out to be correlated with a third, completely unexpected, bad outcome.
You had wrong-way risk.
So you thought you hedged your risk, but it turned out to be correlated with a third, completely unexpected, bad outcome.
You had wrong-way risk.
4/ In finance, the classic example of wrong-way risk also involves insurance.
Back before CDS were cleared, there was a real concern that the same turmoil that caused credit events and bankruptcies could prevent CDS counterparties from making payments.
Back before CDS were cleared, there was a real concern that the same turmoil that caused credit events and bankruptcies could prevent CDS counterparties from making payments.
5/ Wrong-way risk has a "right-way" counterpart. Options are a great example of this: calls get "more long" the more markets rise, adding exposure when it's most beneficial. Conversely, as markets fall, put options get more short, providing greater protection.
6/ However, in 1987, purchasers of "portfolio insurance" (basically synthetic put options) discovered that if markets fall fast enough, and enough people are trying to get more short, you end up exacerbating the problem.
They thought they had right-way risk; they were wrong.
They thought they had right-way risk; they were wrong.
7/ By the way, if this second-order, compounded effect sounds familiar, it's because it's sometimes called gamma:
8/ Earlier this week, an inverse volatility product did exactly what it was supposed to do, and imploded.
When vol spiked, XIV lost value and had to reduce the size of its short. That required buying more vol, which in turn drove vol higher...
It's a vicious wrong-way circle.
When vol spiked, XIV lost value and had to reduce the size of its short. That required buying more vol, which in turn drove vol higher...
It's a vicious wrong-way circle.
9/ These wrong-way risks hold a special place in the pantheon of risk. They're not as obvious as first-order exposures, but they're far more common than tail events.
Worst of all, they're often ignored (until it's too late) because they can be difficult to quantify.
Worst of all, they're often ignored (until it's too late) because they can be difficult to quantify.
10/10 We're all trained to look for the "natural hedges" in our portfolios. I encourage everyone to also do just the opposite, and consider what wrong-way risks you've acquired.
Step carefully, and that 🏠 could be yours!
Step carefully, and that 🏠 could be yours!
