Event Risk and Its Management
Event risk involves a severe and sudden shock that can arise from any general type of risk, including human error, operational risk, natural disasters, currency devaluations, and stock market crashes.
Difficult to predict
Event risks are difficult to predict, but once an event strikes, we know there will be aftershocks. Hence, it is important to readjust quickly to new conditions--this means re-evaluating risks, looking for new risk concentrations, and taking corrective action if necessary.
Events can trigger liquidity crises that may make it difficult to readjust or find funding for positions.
Often the initial shock is not the worst: One event can precipitate other events and lead to contagion across markets, which becomes systemic risk that affects everyone.
One way to prepare for event risks is to conduct regular stress testing. The greatest challenge in stress testing is generating credible worst-case scenarios that show how particular events could affect all relevant markets. For example, we might have a stress test of the U.S. markets: A computer virus cripples Microsoft operating systems and the U.S. equity market starts to sell off. How far will it go? How will other global markets react?
A crisis management process should be in place to prepare for potential events. Essential to crisis management are:
- Appointing a central point of leadership with quick and comprehensive access to information
- Defining a process for communicating within and outside the firm
In volatile market conditions, liquidity often dries up. In the above-mentioned October '97 liquidity crisis in Brazil, traders reported that bid offer spreads (when available) were so wide that it was difficult to tell whether the yield curve was upward or downward sloping. Without reliable (and tradeable) quotes for securities, there can be no trading--you won't be able to get out of your position.
Liquidity risk can also be viewed from the funding perspective--that you will not be able to raise sufficient funding for your illiquid assets.
Although it helps to analyze various liquidity indicators for each security (for example, bid-offer spreads, daily volumes traded, average trade size, number of market makers), liquidity risk is difficult to measure in a consistent manner (liquidity risk modeling could be the next breakthrough in risk management methodology).
Events in one market can easily trigger large movements in other markets in a domino effect. Therefore, we must understand that the benefits of diversification cannot always be counted on=particularly during crises. Risk managers should always be aware of contagion risk and identify potentially hidden concentration risk by understanding the connections between markets.
Contagion is an effect of globalization, where markets are all interconnected and risk can spread quickly.
The effects of contagion are illustrated in the fall of Peregrine. This Hong Kong investment bank sent the global markets reeling on January 12, 1998, when contagion occurred. What precipitated Peregrine's fall was overconcentration in Asia, in particular an Indonesian $265 million loan to a taxi company named PT Steady Safe. Peregrine's fall sent shockwaves throughout the global markets.