RISK HOLES AND LIQUIDITY RISK

In previous articles, we have described the basic dimensions of financial price risk used by derivatives end-users and financial institutions to describe their exposure to fluctuations in financial prices: delta, gamma and vega.

LIQUIDITY RISK

In addition to this quantification of the effect that movements in spot and implied volatility can have on the value of a derivatives position, there is the risk of a liquidity vacuum.

A liquidity vacuum is the nightmarish scenario that occurs when bid/offer spreads for the financial instruments, particularly derivative instruments, widen out to levels that make it prohibitively expensive to deal. In the worst kind of liquidity crisis, you can imagine the situation where bank dealers refuse to pick up the phone and make prices on over-the-counter products that they themselves sold to their customers.

In exchange-traded markets, there is a legal requirement for market-makers to show prices to their customers. In some markets, the bid/offer spread size is capped. Market-makers are protected by the authorities of the exchange who will suspend trading in a particular instrument or who will temporarily stop trading if a particular instrument looks susceptible to a run.

Note that liquidity risk can enter into markets for financial instruments that are being sold en masse or that are being bought in a popular mania. In the latter case, it may be impossible to secure supply of the underlying stock, causing the stock's price to "gap" or jump at discrete, large intervals. Market commentators who label the current Internet sentiment as a mania have cited the gaps in trading in these stocks as evidence of the mania. Brokerage houses seeking to protect themselves from the unreliable liquidity in these markets have imposed restrictions on margin trading these stocks.

RISK HOLES

There are many definitions of the term risk hole used by experienced dealers. Some of them use different terms to refer to the same phenomenon.

A risk hole occurs in a portfolio of assets if, for a specific region of one or more parameters relevant to the pricing of the assets in the portfolio, the exposure to great loss is localized and unhedged.

The classic example of this is the position of the market-maker in a one-sided market.

Consider the case of a Canadian dollar foreign exchange options trader during a Quebec separation referendum.

Each of his customers will be paying him for out-of-the-money US dollar calls/Canadian dollar puts in every period that includes the referendum date. No matter how much of a premium in terms of implied volatility (when compared to the at-the-money options for the same period) he charges for those out-of-the-money Canadian dollar puts, the customer will pay his offer.

What does this mean? He has two kinds of risk hole here (at least).

First, he is exposed because he will be very short gamma if spot trades higher. He will get shorter gamma as spot trades higher. This means that he will lose increasing amounts of money if spot trades higher and his position gets shorter and shorter US dollars (and longer and longer Canadian dollars) at an accelerating rate.

Second, if spot does trade higher, it is likely that implied volatility will jump as well. If spot trades higher, the options market maker will be getting shorter and shorter vega, at an accelerating rate.

Third, if spot trades higher, the forward points are likely to move to the right due to the spike higher in Canadian interest rates. This will have the effect of compounding his gamma problem and his vega problem.

These are just the risk holes that derive from market risk. In addition, there are operational risk holes as well. The options dealer will face a liquidity vacuum in the spot market. He will need to buy US dollars against Canadian dollars aggressively as the Canadian dollar collapses. The kicker is that he will have a more difficult time doing so as the spot market dries up. He will have an even more difficult time hedging his exposures in the options market and the forward market.

One famous currency options interbank dealer named Naseem Taleb, writing in his book Dynamic Hedging, has referred to this effect with a humorous analogy. Imagine crowding as many people into a movie theatre as it will fit, starting the movie and yelling "Fire!" You get the idea. Finally, our poor market-maker will have to deal with a computer system and a back-office system that will be increasingly prone to errors as the amount of processing volume they must handle increases exponentially in times of crisis.

RISK HOLES FROM IGNORANCE

Risk holes can also arise because of the ignorance of the end-user about the behavioral characteristics of the product they are dealing. Now imagine the naïve fund manager who thinks that the market is overdoing this premium for out-of-the-money US dollar calls/Canadian dollar puts. Naturally, he sells them. He has all of the problems described above that face the market-maker. Chances are he does not earn the bid/offer spread on the transaction (that has naturally inflated due to the panic about the uncertainty of the separation referendum's outcome). Nor will he have the direct access the options market-maker has to the underlying markets.

What is worse, let us imagine that he does not have the systems or the training to assess and measure his exposure to these risks. He could stand to lose all of his fund's money and more in the worst-case scenario. Understanding risk involves breaking it down into terms that we can manage. Managing risk means, in many cases, avoiding risk holes and smoothing exposures so that they fit into reasonable tolerances, while still positioning ourselves to take advantage of favorable market moves if and when they occur.