Directional and Non-Directional Risk
Free Video on Directional and Non-Directional RiskThe following video was recorded for the Certified Hedge Fund Professional training program. In this video, you will learn about directional and non-directional risk, different types of directional and non-directional risk and the advantages and disadvantages of each. If you are reading this via RSS or email, please click here to watch the video.
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Transcript for Directional and Non-Directional Risk
In this short video we will discuss directional and non-direction risks. The topics that we will cover include what is a directional risk, the types of direction risks there are, what a non-directional risks is and the types of non-directions risks that affect a portfolio as well as the advantages and disadvantages of the different types of risks.
Taking direction risks as an investors entails initiating exposure to the direction of movement of a financial instrument. For example if a portfolio manager believes the price of RBM stock will move higher or lower, he will take a position that is either long the instrument or short the instrument which is considered initiating directional risk. These directional exposures are measured by first order or linear approximations. A long position means that an investor benefits if the market moves higher, while a short position means that an investor benefits if the underlying market moves lower.
The beta which has been discussed in prior videos is the systematic risk for exposure to general market movements. Beta is calculated using regression analysis. You could think a beta as the tendency of a securities returns to respond to swings in the overall market. A beta of 1 which corresponds to a square of 1 indicates that a securities price will move with the market. A beta of less than 1 means that a security will be less volatile than the overall market. A beta of greater 1 indicates a securities price will be more volatile than the market.
DV01 or the dollar value of interest rate is the exposure an investor has to interest rates. This could come from direct directional exposure due to speculation in the interest rate market on interest rate instruments or having exposure due to present value on assets that have future values. Additionally, options have exposure to interest rates which generate DV01. Investors can gain exposure to interest rates in numerous ways which include purchasing or selling bonds, buying or selling year-old contracts, investing in the interest rates white market or using the overnight repurchase agreements. There are hundreds of products that produce interest rate exposure to government rates, corporate rates or municipal rates.
Duration is a term that is used to determine the measurement of how long in years it takes the price of a bond to be repaid by its internal cash flows. As prices our bonds move higher. The yields on a bond will move lower. Duration talks about the tenor of an interest rate curve. Bonds with higher durations carry more risk in general and have a higher price volatility than bonds with lower durations or lower tenors. The pricing yield of interest rates and measurements are inverse.
There are numerous types of non-direction risk. Non-directional risks include non-linear exposures to hedge positions and exposures to volatility. These non-directional exposures are measured by exposures to differences in price movement or quadratic exposures. A basis risk may rise when a position involves two products that are similar but not exact. For example, if a portfolio manager has a position where they are long light sweet crude oil and short medium sweet crude oil, the difference between light and sweet is considered a basis and there is a relative movement differential.
This also can occur in the interest rates sector with similar bonds. For example, there is trading of on the run bonds which are the newest bonds issued by the government or off the run bonds which are bonds that are not the newest bonds. The difference between the two is a basis. When trading a basis, the portfolio manager is speculating on the widening or contracting of the two instrument relative to one another. Stock investors will trade pairs of stocks where there are long one stocks such as Coke and short Pepsi against it. This type of highly correlated pair creates a basis.
Residual risk is a risk which is common in many portfolios. It is the risks that occur after all known risks have been calculated. This type of risk can be covered with a liquidity reserve as a back stop. Convexity risk deal with the second order effect of interest rates. It is the probability of loss resulting from adverse changes in the price of a trading position due to changes in the yield of the underlying asset. The convexities associated with the interest rate curve and the differential and the movements in one tenor relative to another.
Directional risks have the advantage of liquidity and are generally transparent. They benefit in an investor by allowing him to easily enter and exit the marketplace. In general, directional risks are volatile and can quickly move in an adverse direction. A non-directional risks are generally market-neutral and are not correlated with general market direction. They usually have a beta of zero relative to a market. This type of risk are usually less volatile when compared to directional risk but the liquidity can be weak and the markets can be opaque.
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