Risky Business
by Barbara Clapham

Just about everyone is doing something to prepare for Y2K. Many people have altered traditional travel patterns. Others, anticipating possible disruptions in water or electrical service, are stockpiling wood and bottled water. Still others, nervous about disruptions in the capital markets, are changing investment strategies and asset mix. All of these measures have one thing in common. They are performed to hedge risk.

Whether or not Y2K poses a real threat or not, there is no question it is creating turbulence in the markets. According to the Investment Funds Institute of Canada, in October net sales of mutual funds fell about 50% over the same period last year, due to investor nervousness about Y2K, coupled with rising interest rates.

Although a strategy of avoiding the stock market may reduce Y2K uncertainty, it creates a different kind of risk. Unless investors who are avoiding mutual funds are keeping their money under a mattress, the funds are most likely parked in a bank account or similar "safe" vehicle. Many are holding their assets in money market mutual funds. Is this a risk free strategy? What about the opportunity cost of not investing in equities? Not only is our economy humming along quite nicely right now, but we know that over the long term equities outperform money market instruments.

The best strategy to hedge risk is to first define and measure your risk exposure, then take appropriate action. The problem with Y2K is that there is no easy way of quantifying this risk. The amount of risk, if any, is unknown. For money managers, the problem of how to measure risk in their portfolio may be complex, but there are methods available to help determine the risk exposure of the fund. One method is Value at Risk (VaR). This concept was explored in depth at our first annual Risk Management Conference in Quebec last August.

VaR has been offered in some circles as being the answer to the question of how to measure risk, encompassing risk in one, easy-to-use number. However, VaR is not a panacea. External events play a significant and unpredictable role in risk management.

Nowhere is this better illustrated than in the case of the hedge fund Long Term Capital Management. The LTCM fiasco was so significant that the Federal Reserve Bank of New York was forced to coordinate a bailout to prevent potentially disastrous declines in world markets. This fascinating story is captured by Professor Philippe Jorion.

Today the availability of risk management tools is somewhat limited. However, products are expected to proliferate rapidly over the next few years. As you will read, Dow Jones plans to introduce country specific indexes with futures, options and exchange-traded funds based upon each index. Many other products will come on stream to help managers hedge their risk exposure.

In the meantime, with the year 2000 almost here, it may not hurt to buy some bottled water, just in case.

Contex Group