Thursday, May 15, 2014

Value At Risk | Is volatility back?

In the movie Margin Call, which was apparently inspired by the collapse of Lehman Brothers that precipitated the Global Financial Crisis, a young analyst (Zachary Quinto), discovers that the firm is massively overexposed to Mortgage Backed Securities (MBSs). It had made a lot of money on these in the past.

The tension builds nicely when a crisis meeting is called involving, among others, various members of the risk department. Ramesh, played by Aasif Mandvi, obviously here for his mathematical abilities, utters the immortal words – “….I’ve just been looking here a little closer, and it’s these VAR numbers that are really setting this thing off”.

VAR stands for “Value At Risk” and is a well used method of quantifying the hazard attached to the positions that any trading entity might have at any particular time. The irony in their use at this stage in the movie is that it is far, far too late in the day to coming to such a conclusion. If the tool was being used in any meaningful way, the “VAR numbers” would have triggered wholesale risk amelioration measures a long time before.

There are many scholarly papers available for VAR, and most of them delve deeply into the concepts of Standard Deviation, Normal Distribution and Variance, among others. But simple is best and we prefer to basically calculate the aggregate total exposure of all open positions. It comes down to an exercise in adding up: Take the maximum potential loss on each open position at any time and total them all. The result must fit within certain criteria: an absolute maximum of 2% of risk of loss on any single position and a total risk of loss on all positions of 6%.

Is volatility back?

EURUSD had a very busy time over the last few days, ever since the remarks made by Mario Draghi of the ECB at his press conference earlier in the week. The volume of trading in this instrument even suggests that it is possible a trend change might be taking place. It is too early to say yet but the situation will be monitored.

The Gold contract (chart above), which we entered for a short period yesterday, showed serious bi-directional volatility, to the extent that we decided to get out with a small profit rather than undergo the kind of “whipsawing” that this kind of activity can give rise to.

Other pairs, such as USDJPY, are still going sideways, but we are positioned for the possibility that next week this particular instrument will break out of its range.

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