Event Risk

Event Risk

Event risks are usually risks imposed on the markets by external non predictable factors. Wars, disasters, terrorist attacks, current tension between Russia and the west, advancement of ISIS in Iraq, etc…are all instances of event risks.

Depending on their severity, event risks can significantly impact the financial markets and therefore traders need to keep them on their radar as they unfold and progress. Due to markets being highly integrated, a crisis arising in one part of the world can easily spill over to the other markets/regions causing global stress.

In this article we are going to discuss how these event risks can impact our day to day trading.

 

Event Risk Barometers

Your first step is to see if an event is gaining traction and is beginning to become an Event Risk. We introduce two stress indicators which are widely used by market practitioners and can act as barometers.

The first  indicator which we have discussed before in previous articles, is the  Volatility Index (VIX).
Volatility Index, also known as the “Fear Index”, is a measure of  investor’s sentiment towards market risks. Generally speaking, rising Volatility implies that traders are discounting a significant  risk factor to the current prices

VIXvSPX

Chart: VIX v SPX

The second indicator is a measure of trust between the banks, this is called “ Ted Spread”. The TED spread is the difference between the three month lending rate (LIBOR rate) at which banks lend amongst themselves and the corresponding three month government interest rates.

Usually the interbank lending rate is higher than the government rates to motivate banks to lend to each other.

When the market feels threatened by a risk event, the difference between interbank lending rates and the government rates, increases significantly.

This is because the uncertain situation caused by the event risk has made banks worry about the security of their own funds, hence they require higher rates as trust is starting to fade. Higher rates will naturally slow the supply of liquidity which in turn pushes asset prices downward as there is now less money to be invested.

The chart below shows the US 3 month government rate and inter-bank lending rate Spread (TED Spread). Notice how spikes in the TED spread has been followed by periods of contraction or negative returns in S&P 500.

TEDvSPX

Chart: TED v SPX

By Monitoring the patterns and trends of the above indicators, traders can take an educated guess on the severity of the current events and see if they are turning into event risks.

 

Market Impacts

Now let’s see how these event risks can impact different markets. Usually event risks create some degree of market stress and cause a Risk Off environment where fund managers become risk averse and let go of their risky assets such as stocks which tend to become more volatile under these circumstances, in favour of the safe assets such as  government bonds which tend to have more predictable returns. A government bond is a debt issued by the governments promising to pay a periodic interest plus the principal at the expiry.

When a crisis hits, investors desire to sell their investments increases dramatically as cash is now king!

As a result, investment managers especially those who manage large sums of money, start to pull out from assets with small trading volumes (less liquid) and invest heavily into those which are trading actively with larger volumes.

The trading implication of such rotation is the visibility of higher volatility in smaller less liquid assets. So, if you are a small cap trader or if you usually trade exotic currencies/indices with low volumes, you may start seeing wider spreads, more slippage, higher margins;all of which add to your transaction costs significantly.

In these scenarios the Foreign exchange market exhibits rather interesting behaviour. Naturally you would expect that the currency of the country that has been hit by an event risk to lose value. This is true for most currencies except for the US Dollar.

This is because the US dollar is the funding currency for most of the world investments. When prospects and security of returns are threatened by a crisis,  the risk averse corporations and institutes who have previously borrowed in US dollars to fund their investments, usually sell their assets and convert the cash back to US dollars to avoid further deterioration.

This creates a huge demand for US Dollars and consequently a strong headwind to risk currencies such as Australian Dollar, Canadian dollar, emerging markets currencies etc….
One point to take note of is that the Swiss Franc and the Japanese Yen usually show the same behaviour when the global economy is affected by an event risk.

Chart: USD v SPX

Chart: USD v SPX

Commodities however show a mixed pattern. Industrial commodities, like copper, zinc, aluminium will show a negative reaction in response to more economic uncertainties created by the event risk.The same can be said for agriculture and energies. However, in the case of energies, the location of the crises play’s a major role. For example, an event risk in Persian Gulf where most of the world’s oil pass through, can significantly increase the prices of energies. Unsurprisingly Gold and precious metals appreciate during a crises.

Overall Equity markets in general, show a negative reaction to event risks with some being affected more than the others. The Consumer discretionary sector which is made up of companies that produce services or products which are not life necessities, can be seriously impacted. Retailers, automobiles, hotels, leisure centres are among the consumer discretionary sector. Along with this sector, basic materials and financials are also negatively impacted. The surviving groups are usually the utilities and telecom which are more resilient towards external shocks.

 

Conclusion

Market impacting event risks always come unexpectedly. Whilst we can not predict them, we can set up our portfolios in a way that minimises this risk by using robust risk management and a diversification of strategies. Another way to avoid price shocks is to adopt a directionless spread trading system.

Diversification of models needs to be done before an event occurs. We see too many traders who neglect this fact and trade without knowing the true impact.

At Trade View we believe in building multiple trading strategies which can be back tested and analysed on such event risk data.

 


Most retail traders who have joined our programs say they encountered setbacks because of poor strategy planning and execution.

Our hands-on Professional Traders will support you in building your strategies into automated trading models.

Register now for our next In-House Systems Building in Melbourne.


button_bk2

 

Leave a Reply