8: Risk Management

Question 1

Primary forces that influence returns during a tail event

Answer 1

1. Higher flow-level risk for individual firms
2. Delevering and derisking at the same time
3. Market makers widen bid ask spreads and reduce liquidity

Question 2

Disadvantages to holding illiquid investments

Answer 2

1. Miss opportunities
2. Liquidity risk increases as prices decrease
3. Liquidity risk is not diversifiable when there is free flow of capital
4. Liquidity risk depends on aggregate investor behavior (not a continuous risk)

Question 3

Notable high liquidity-risk periods

Answer 3

1. Panic of 1907
2. Demise of LTCM in 1998
3. Falling RE prices in 2007

Question 4

Capital Market Theory (assumptions)

Answer 4

1. Investors have single horizon
2. Investors are price takers
3. Portfolios are based on mean variance - CAPM (does not account for higher moments)
4. Volatility and trading costs are assumed to be constant
5. Prices are based on supply and demand driven by fundamentals

These do not hold in practice; especially during crisis/liquidity events

Question 5

Alternative Approaches to Reduce Tail Risk

Answer 5

1. Diversify by risk, not just by assets
2. Actively manage volatility
3. Use low-correlated alternatives (e.g. global macro, volatility arb, managed futures)
4. Use low beta equities
5. Have tail ever plan before it is needed