In March of 2021, KRM22 published a blog titled “Always Expect the Unexpected”. Within a fifteen-month window there was an unprecedented list of events that no one could have predicted including a global pandemic, severe weather changes, political and social unrest, a stock market crash and rebound, negative commodity prices in Crude Oil and a powerful stock squeeze. Remarkably, the impact from Covid-19 remains and global unrest, albeit for a different reason, is front and centre.

At KRM22 we work directly with front line Risk Managers in the Capital Markets arena where our conversations are heavily focused on how to prepare for the unexpected. Together, we have yielded ideas and methodologies for identifying a wide range of market risks in unpredictable times.

What type of risk are we facing now?

An event within an unknown end date: US General Milley: “Ukraine war likely to last for years”

The Russian-Ukrainian conflict is in the middle of its second month. Many believed this conflict would be brief given the might of the Russian Army. This has not been the case. Citizens of the world are horrified of the images of civilian casualties. These scenes are difficult to view, and we all pray for those in danger and for those already lost.

On top of the human toll, markets are faced with new risks brought by the conflict. The world was already experiencing dramatic effects from western countries continued reflation processes while supply chain issues began impacting inflation.

While futures and options markets are challenging to navigate in normal times, the Russian -Ukraine military conflict has added a large and unpredictable level of uncertainty that exacerbates supply chain issues due to the food and energy production of Russia and the Ukraine. Equities, interest rates, metals, cryptocurrencies, commodities and nearly every asset class around the globe is impacted as investors and traders vie for stability and safety in the event this situation escalates into something larger.

What can be done to measure and/or reveal the risks?

In the most extreme market events, correlations between products break down and can remain de-coupled for extended periods before returning to “normal”. The idea of shocking prices and volatilities by extreme amounts is necessary.  Shocking commodity prices by 100% (or more) to the upside is not an unreasonable scenario. LME Nickel just had an event where this type of price movement occurred even though it seems there was no correlation to the conflict at all.

In dire situations, the monetary flight to deliverable assets can cause an incredible upward surge in prices. Having these risk situations pre-calculated for a given product or between correlated products is necessary. The magnitudes of price movements increase with the greater uncertainty - we have already seen US Gasoline prices double in 14months. Clearly, this did not happen overnight but what would happen if this Russia/Ukraine conflict moves westward or what if China becomes involved? What would happen if a US energy pipeline was sabotaged?

This same principal holds true for option risk. Shocking volatilities upward by 100% to 200% of current levels is necessary. Liquidity and the ability to trade need to be considered. The P&L of each “1 lot” of inventory is magnified in extreme events. What would be the estimated bid/ask spread on futures and options in a “world crisis”? How much would it cost to liquidate? Are you short “teeny” options? What is the delta of a position after a 100% increase in underlying price? Is there access to inventory for deliverable commodities? Should we decrease the position and trading limits across the entire firm? What is an acceptable clip size and max position in the current environment? What is my percentage of open interest?

There is no exact answer...but being prepared is the key response

It is anyone’s guess as to the end, or outcome, of this current conflict. More than ever, risk managers must use available information and risk tools to identify and reveal potentially dangerous situations. Running these “disaster scenarios” in advance of a market event allows a risk team to expose/diffuse a future problem and live to trade another day.

Please contact MatthewC@KRM22.com for information on KRM22 Market Risk Solutions for your firm

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