The Dog that Didn’t Bark

If you are puzzled by the low volatility in financial markets, you have good company. Richard Thaler, the Nobel Prize winning economist is also puzzled and suggests a Sherlock Holmes strategy to understanding this phenomenon at the “riskiest moment in our lives.” The lack of volatility is concerning and may be explained in part by the way animals either flee or freeze in a dangerous situation. Investors seem to be frozen in place with no place to flee. He questions why investors have not lost confidence in a tax break given the lack of results in congress so far with this administration.

Central bank policy has not made it easy to find a place to flee to by forcing investors to choose between no return and risky returns. The “risk free” return in treasuries is not an attractive option to equities. This would suggest that we may be in for a big disappointment that may finally spook the market, but current volatility, like the sleeping dog, is not giving any indication of an underlying problem.

Risk managers, investors and regulators looking at VaR numbers may be looking at the wrong vital signs to diagnose risk in this environment. That dog is asleep. VaR is fundamentally a function of volatility and these are not about to flash any warning signs of potential losses under current conditions. At times like this risk managers need to be creative at challenging the assumptions of risk models to uncover potential risk scenarios that would otherwise go unnoticed.

Here are 5 questions to start with to uncover model risk in your portfolio:

1. What correlation assumption is used in your VaR and stress scenario?
2. What is the highest volatility in the market data used to measure your current VaR?
3. What would happen if correlations and volatility were to increase significantly?
4. How would the unwinding of low-vol strategies common in many ETFs impact your portfolio?
5. What exposure changes would be needed to remain within target volatility under a stressed vol scenario?

Fortunately, Red Swan Risk has perfected the tools, consultancy, and best practices that prepare our clients for the unknown.

Contact Red Swan Risk today for a demonstration of our efficient solutions for these challenges and more.