The devastating tragedy that took place last Friday evening in Paris left the world shaking in more ways than one and even before the dust had settled and we had a chance to realize the immensity of what happened, the financial market was already bracing itself for impact.
Traders and brokers alike were left wondering how this heinous attack would impact their portfolios and evaluating what measures they should take in order to minimize their exposure.
Specific to the Paris attacks, because the events happened during the off market session and at the very beginning of the weekend, time was in favor of traders, allowing time to think, understand and perhaps even anticipate the possible effects. For sure there would be some gap in the market opening and some volatility during the early stages of opening, but without having to make rushed decisions, the impact was diminished.
A brokerage that recognizes that it is in a risky business by nature, needs to understand that in black swan-like events, it needs to have a previously designed strategy in place.
Furthermore, because the CAC begins trading 9 hours after some other relevant indices, there was time to see how other correlating instruments performed at opening and to hedge indirectly against other correlating assets in order to avoid or reduce the opening gap. Other events in the past have happened during normal trading hours and some even during peak times, thus not allowing traders to think with a leveled head.
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The effects on the financial market after Friday’s terrorist attack were minimal, with no signs of panic in the market and reflecting the normal defensive sentiment expected from investors. This isn’t to say however, that even though world-changing events such as this one tend to have minimal long-term effects on the market, that a brokerage isn’t exposed to high risk.
A brokerage that recognizes that it is in a risky business by nature, needs to understand that in black swan-like events, it needs to have a previously designed strategy in place. The question for a broker is not whether it will be hit by a black swan event, but how hard will it be hit and how quickly it will recover. Having a strategy in place may very well be the difference between a brokerage facing bankruptcy and/or losing a lot of money, or facing minimal losses.
How should a broker prepare itself for a black swan event?
- Establish a disaster recovery procedure
- Look for hints in the market. Paris’ attack, similar to a natural disaster, had no prior hints, however, some black swans, such as the Swiss franc incident earlier this year did
- Develop a risk strategy. A risk management committee within a brokerage should be established and charged with the task of designing a risk protocol regarding limits, hedging strategies, value at risk models, etc
A brokerage should have policies in place and proceed accordingly in the event of a black swan. Some questions to ask yourself as you establish your risk strategy are:
- Should we hold trades and for how long?
- Should we increase spreads?
- Should we increase margin requirements?
- Should we hedge?
- Should we use options to hedge ourselves?
- What is my risk taking behavior? (How quickly do I implement strategy? Better safe than sorry?)
No plan can be perfect and it should be adapted to every situation, but having one may take away the pressure of having to make decisions on a whim and allow you the time to process an event, whether a natural disaster or a terrorist attack, putting your human emotions ahead of your financial ones.