Event Risk and its importance in today’s world
In 2008, the world was about to face the most acute financial crisis in its modern history, with quantitative easing programs being the main defense mechanism against the many challenges monetary authorities of the most profound economies around the globe were faced with. In 2020, the Covid-19 pandemic caught the world unprepared, with many governments imposing lockdown measures that caused difficulties to trade and effectively shrank the global GDP. A new era in terms of negative interest rates and vast supply of money appeared to be the new norm until very recently: with inflation raising its ugly head, the key Central Banks around the world, including the Fed and the Bank of England, have started raising the key policy interest rates. Today, the whole world is becoming a witness to the war between Russia and Ukraine, taking place right in the heart of Europe and characterised by many as a step back in the dark days of the not-too-distant European history.
Event risk refers to the possibility that an unforeseen or unexpected event could negatively affect a company, industry, or a security, thereby causing a loss to investors or stakeholders. The above-mentioned events (financial crisis, pandemic and the war between Russia and Ukraine) could, therefore, be characterised as examples of event risk. These types of risks seem to become more and more critical for Risk Managers as they have to be closely monitored, analyzed and, on a frequent basis, their effects and impact on investments must be assessed.
Undoubtedly, certain mechanisms exist to reduce the financial impact of an extreme event, such as a fire or a natural disaster, including insurance coverage for an organisation. In addition, certain financial products, such as options and swaps, could be used as hedging mechanisms against extreme events. Credit default swaps can also be utilised by investors as a mitigant to those unexpected events.
Risk Managers have to be on top of developments in order to identify potential hazards, determine the probability of occurrence and assess the severity, when an unexpected event occurs, on a specific investment and, more importantly, the potential effect on the whole investment portfolio. This is critical as companies, Alternative Investment Managers (AIFMs) and other organisations must ensure that their personnel possess relevant experience, have an understanding of the political and economic landscape so when an extreme event takes place they will be in a position to face the new realities and take the appropriate measures to protect the investors and stakeholders, despite the fact that predicting an extreme event is by definition a difficult task.
It is essential that Risk Managers perform a liquidity assessment. They need to assess the liquidity of the portfolio by effectively implementing liquidity stress testing on the asset side. Furthermore, the ability of an open–ended fund to fulfill redemption requests in a timely manner should be evaluated (liquidity stress testing on the liability side). Moreover, a descriptive letter could be sent by the company to investors and stakeholders analysing a specific event and explaining how the event will affect the fund and the investments. The companies, the AIFMs and the organisations should assess their cash flow ability in case an extreme event occurs and act proactively for the ultimate benefit of the investors and stakeholders.
The contagion effect must also be assessed by Risk Managers both at an industry level, as well as in terms of correlation between individual securities in an invested portfolio. As a mechanism of minimising the contagion effect, diversification could be a solution. Therefore, funds and participants in the asset management industry must ensure that asset allocation thresholds are not breached, and, in case of extreme events, the appropriate procedures are in place to eliminate the impact of event risks and, if necessary, amend the current asset allocation of the fund. Furthermore, investing in high credit quality securities may potentially act as a mitigating factor against event risk.
Once an event occurs, Risk Managers must assess the immediate aftershock impact on the portfolio and how the particular event may cause other risks to arise. As a result, Risk Managers must continue monitoring risks relating to the portfolios and the investments in securities that they monitor and, at the same time, attend seminars or other courses that will improve their knowledge in terms of effective risk management, specifically, concerning extreme events.
Lastly, today’s world seems to be far more uncertain compared to what the world was like 20 years ago. Therefore, the role of the risk management function in essence becomes more and more significant for corporations and organisations. In this globalized world, risk management becomes a dynamic function and the people employed in the area must maintain, apart from a quantitative understanding, a global politico-economic comprehension of modern realities in order to be able to assess any potential dangers to each specific fund that they monitor and identify ways of mitigating those risks for the ultimate benefit of investors and stakeholders.