To say the last few weeks have seen unprecedented volatility in a wide range of markets is not an over-exaggeration. Equities tend to receive the most attention, but bonds, currencies, commodities and credit have all seen significant rallies and sell-offs, with some of the moves seeming very counterintuitive and inconsistent with recent correlations. The rapid deleveraging of the global financial system has seen a rush to raising liquidity (cash or equivalents) and a need to reassess the risks associated with a broad range of business structures.
One of the challenges of managing risks in this environment has been the dynamic manner in which many institutions manage their risk exposures. Simply put, as the risk amount changes, the risk is readjusted by either directly changing the position size or offsetting the change with another position. This strategy has been under significant stress during the last few weeks as dramatic sell-offs and market rallies, sometimes at night and sometimes hitting exchange limits with large gaps in prices from day to day, have potentially required significant repositioning using dynamic hedging. Static hedging, or the purchase of protection to offset the change in value, comes at a much greater cost in normal times but can add value in these types of volatile environments. Only with hindsight will we truly know which firms, industries and strategies turned out to be the most effective risk managers through this pandemic. I do believe we will see some significant impacts based on how effective or ineffective these risk management programs proved to be.
Last week saw a dramatic rally in risk assets as the two-pronged impact of massive monetary and fiscal stimulus put a floor under sinking markets and provided much-needed liquidity to markets. I continue to have great optimism that modern science will ultimately, and in the not too distant future, generate a breakthrough for treating and protecting people from the virus. I expect that until that time, markets will focus more on the future path of the pandemic, in terms of the length of time to return to a more normal economic state and the resulting long-term changes in the economy and behaviors. Over the next few weeks, market volatility should decline but remain elevated relative to recent history, while the overall market direction will be driven by fundamentals, not deleveraging or technicals.
During this challenging time, please stay safe and be well.
This blog post is for informational use only. The views expressed are those of the author, Dave O’Malley, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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