Event: Hedging Illiquid Assets
Date: October 21 , 2008
Time: 5:30 Registration, 6:00 Program Begins, 7:30 Reception
32 Old Slip
The International Association of Financial Engineers is pleased to invite you to
A Liquidity Risk Committee Event
Presentation By :
Peter Rappaport, JP Morgan Securities
Steve Allen, Fellow, Masters in Mathematics in Finance Program, Courant Institute, New York University and IAFE Board Member
Hedging in liquid markets requires no hard choices: the hedge ratio is the same whether designed for a day or a quarter, and quarterly value at risk is simply a scaled-up version of daily. This equivalence has enabled financial institutions with long time horizons to manage earnings at risk on a daily basis. Following this “liquid markets” recipe in illiquid markets can be disastrous.
Recent experience in the U.S. leveraged loan market illustrates: the hedge that looks best over a day is nevertheless very risky over a quarter. In fact, it is five times more risky than the best hedge over a quarterly horizon. On top of this, a liquid markets perspective underpredicts by 50% the capital required by this hedge over a quarterly horizon. These and other pitfalls result because the relationship between the fundamentals of the asset and hedge only emerges in the long run; in the short run it is masked by stale prices. In other words, in illiquid markets, the long run is not simply the sum of short runs. Risk management must make the hard choice of whether to hedge for the short or long run.