Over the last couple of days, we experienced price corrections in multiple asset classes across the globe. Stock markets and cryptocurrencies dropped sharply, while treasury yields declined. Japanese stocks were particularly affected, after the Bank of Japan increased its key interest rate on 31 July, 2024. This triggered a rally in the Japanese Yen. Following two weak trading days end of last week, the Nikkei 225 index dropped by 12 percent yesterday, the biggest one-day loss since October 1987. Today, the market strongly recovered. In early trading, the Nikkei 225 is up around 9 percent.<\/p>\n\n\n\n
In this article, we discuss to what extent large price jumps in asset prices can be a threat for banks. The focus is on the so called gap risk, which describes the situation in which the price of an asset significantly changes between the closing price and the next day\u2019s opening price.<\/p>\n\n\n\n
Potential losses from delta hedging strategies (Short-Gamma)<\/strong><\/p>\n\n\n\n In nowadays world, banks typically have no or only a limited directional asset price exposure, i.e., material long\/short equity, FX, or interest rate trading positions. Yet, investment banks offer their clients a wide range of derivatives for which they need to hedge the market risk by other financial instruments, for instance the underlying assets.<\/p>\n\n\n\n For option books, the so-called delta hedging plays still an important role. It means that investment banks hedge their option trades with clients by an opposite position in the underlying assets. The main challenge with this strategy is that option exposures have a convex payout profile, while the hedging instruments are linear. This means that larger price movements can make the hedging strategy partially ineffective. Notably, this hedging incongruence can be a threat or opportunity. If an investment bank is a net buyer of options (call or put options), it will benefit from higher than usual price fluctuations. The losses on the options are overcompensated by the gains on the hedges.1<\/a><\/sup> In dealer language, this is known as \u2018Long Gamma\u2019. Conversely, if the investment bank is net seller of options (\u2018Short Gamma\u2019), the delta hedging strategy becomes costly for large price moves. In that situation, the losses on the option positions outweigh the gains on the linear hedging instruments.2<\/a><\/sup> However, since this hedging costs are normally only small and in quiet times more than compensated by the time decay of the options sold, derivatives traders often prefer to be \u2018Short Gamma\u2019.<\/p>\n\n\n\n In volatile times, \u2018Short Gamma\u2019 positions can become costly and have a procyclical effect. For equity options, for example, the derivatives dealers need to buy stocks if share prices increase and to sell stocks if share prices decrease. This hedge adjustments are made frequently, often intraday or towards the end of a trading day. For a trader who is \u2018Short Gamma\u2019, it is critical to keep the deviation from the required hedge ratio minimal. Gap risk is therefore a challenge.<\/p>\n\n\n\n Yesterday, the Nikkei 225 index opened 5 percent below the previous day\u2019s closing price, a unusually large price gap. This means that derivatives dealers which were \u2018Short Gamma\u2019 faced large losses already at the beginning of the trading day. During the second half of the trading session, the price decline continued and forced derivative dealers with \u2018Short Gamma\u2019 positions to offload additional shares. By the end of the trading day, the Nikkei 225 index was down 12 percent, the largest price decline observed on a single trading day in over 30 years. The losses of investment banks applying delta hedging were likely material.<\/p>\n\n\n\n Today was presumably an even worse day for derivatives dealers with \u2018Short Gamma\u2019 positions. The Nikkei 225 index opened 9 percent higher. This means that the dealers had to buy back a large part of the shares they sold yesterday, but at a higher price. The enormous gap between yesterday\u2019s close and today\u2019s opening price made the re-adjustment of the hedge positions very costly.<\/p>\n\n\n\n Since large investment banks should have robust market risk and stress testing methodologies in place, Orbit36 regards it as unlikely that the recent market volatility caused banks trading losses in a magnitude they cannot handle. However, there were possibly significant adverse trading PnL impacts for some banks.<\/p>\n\n\n\n Increased counterparty exposures and margin shortfalls<\/strong><\/p>\n\n\n\n The recent market events could though be a renewed reality check for counterparty credit risk, after the collapse of Archegos in 2021 and the turmoil in UK gilts markets in 2022. In both cases, unusually large market moves caused banks large counterparty exposures that were not sufficiently covered by collateral.<\/p>\n\n\n\n Today\u2019s situation is less clear. The market moves in the magnitude observed in Japan over the last few days will likely have triggered substantial margin calls. The key questions is whether the banks\u2019 hedge fund clients and other trading counterparties were always able to fulfill their margin calls as stipulated by the contracts. Possibly, there were some failures and positions had to be unwound. As long as the clients have sufficient capital and liquidity, this is not necessarily a problem for the banks. However, in respect of future crises, it is important to analyze possible \u2018near misses\u2019, including settlement delays or situations in which collateral was temporarily insufficient to fully cover the counterparty exposures.<\/p>\n\n\n\n In our view, it is critical that bank board members ascertain whether their firm\u2019s counterparty risk management processes were effective over the last days. Orbit36 can help board members and senior executives to raise the right questions and identify possible vulnerabilities. Please reach out to us if you have any questions or would like to discuss.<\/p>\n\n\n Over the last couple of days, we experienced price corrections in multiple asset classes across the globe. Stock markets and cryptocurrencies dropped sharply, while treasury yields declined. Japanese stocks were particularly affected, after the Bank of Japan increased its key interest rate on 31 July, 2024. This triggered a rally in the Japanese Yen. Following […]<\/p>\n","protected":false},"author":2,"featured_media":5023,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"inline_featured_image":false,"site-sidebar-layout":"default","site-content-layout":"","ast-site-content-layout":"default","site-content-style":"default","site-sidebar-style":"default","ast-global-header-display":"","ast-banner-title-visibility":"","ast-main-header-display":"","ast-hfb-above-header-display":"","ast-hfb-below-header-display":"","ast-hfb-mobile-header-display":"","site-post-title":"","ast-breadcrumbs-content":"","ast-featured-img":"","footer-sml-layout":"","theme-transparent-header-meta":"","adv-header-id-meta":"","stick-header-meta":"","header-above-stick-meta":"","header-main-stick-meta":"","header-below-stick-meta":"","astra-migrate-meta-layouts":"set","ast-page-background-enabled":"default","ast-page-background-meta":{"desktop":{"background-color":"","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""},"tablet":{"background-color":"","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""},"mobile":{"background-color":"","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""}},"ast-content-background-meta":{"desktop":{"background-color":"var(--ast-global-color-5)","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""},"tablet":{"background-color":"var(--ast-global-color-5)","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""},"mobile":{"background-color":"var(--ast-global-color-5)","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""}},"footnotes":"[{\"content\":\"An identical effect arises if the gains on the options are higher than the losses on the hedges \",\"id\":\"39dce916-f7ef-4ed0-b70a-e2bcc9d009f7\"},{\"content\":\"An identical effect arises if the gains on the option positions are smaller than the losses on the hedging instruments\",\"id\":\"53a52ff6-2b0c-49da-8eb9-cc8458b2267a\"}]"},"categories":[6],"tags":[],"class_list":["post-5025","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-unkategorisiert"],"yoast_head":"\n