Tools to Manage Market Risk

Tools to Manage Market Risk
Instruments may be limited today, but an onslaught of new tools is expected in the near future
by John A. Prestbo

There are far more risks in the investment market than there are tools to manage them. Among the risks are:

* Asset class risk
* Volatility risk
* Liquidity risk
* Interest rate risk
* Credit risk, and
* Currency risk

This list is by no means complete, but it is long enough to compare with the list of tools available to manage risk. Basically, those tools are:
* Futures
* Options
* Exchange-traded funds, and
* Currency forward contracts

However, these tools are not uniformly available to every portfolio manager around the world. Stock-index futures, interest rate futures and currency futures are available most readily in the United States. Canada has a decent offering as well, as does the United Kingdom, Japan, Australia and Singapore. Making these instruments more universally available via electronic trading platforms would help to break the monopoly of a handful of financial centres.

Options are even less readily available, offered mainly in North America and a bit in Europe. They are not familiar instruments for investors in much of Asia or Latin America.

Exchange-traded funds are relatively brand new vehicles that haven't been run around the risk management track much as yet. They are actual baskets of securities, so they don't offer nearly as much leverage as futures and options. That means the familiar risk management tactics would be much more expensive with exchange-traded funds. At the American Stock Exchange, where all of them trade at the moment, they can be sold on a downtick, which means short-selling is basically unrestricted.

Finally, currency-forward contracts are available to hedge currency risk, but their size means a lot of exposure in any one currency is needed to make the use of these instruments worthwhile. As well, portfolio managers have to be on good terms with their banker. Currency futures are still traded in Chicago, but that market has all but dried up, increasing liquidity risk.

Index providers have heard the cry for more risk management tools and are working to develop new indexes that will help meet the demand.

In early July of 1999, Dow Jones announced a new index, Dow Jones Global Titans. It's a 50-stock index containing the biggest of the big stocks around the world. When futures are traded on this index, which will happen in the near future, portfolio managers will be able to hedge their global holdings of large and mid-cap stocks, because the correlations that Titans have with major world stock indexes are quite high.

Dow Jones has also created an extra liquid series of indexes. These are based on Dow Jones Global Indexes benchmarks, but with attention to several parameters that are uniquely important to a derivatives index, such as liquidity, turnover rate, transaction costs, and tracking error. Clearly, not all of these features can be maximized simultaneously. Inevitable tradeoffs exist between market coverage and replicability, turnover rate and sector representation, for example, as well as tracking error and liquidity. In such cases, indexes are constructed to maximize the attributes' combined benefits.

This approach was first applied in 1998 to the Dow Jones STOXX 50 and Dow Jones Euro STOXX 50 indexes in Europe. In the spring of 1999, a Canadian extra liquid series containing 40 stocks was introduced. And in late July, Dow Jones introduced three extra liquid indexes - called the Asia/Pacific Extra Liquid Series, or AP/ELS. These are indexes for Australia (35 stocks), Hong Kong (30 stocks) and Japan (100 stocks). Dow Jones plans to follow with other countries and an Asian regional index. Futures, options and exchange-traded funds will be based on these indexes and traded on the Sydney Futures Exchange. Again, in each of these cases the correlation of the extra liquid index with the benchmark from which it was derived is quite high. That gives money managers confidence that they can hedge their portfolios in predictable ways.

Theoretically, the sky is the limit on extra liquid indexes. In addition to countries and regions, they can be created for sectors and industry groups.

Prepare for the Onslaught
While risk-management tools are somewhat limited at present, there will be an explosion of new instruments in the months and years ahead that will provide portfolio managers will much greater flexibility and risk control. Long-run implementation will begin with the introduction of new indexes and derivative financial instruments. They will come to the marketplace in a rush. Managers must be prepared to read, think and analyze a lot over the next couple of years.

John A. Prestbo is editor of the Dow Jones Global Indexes and markets editor of the Wall Street Journal.

Contex Group