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11 23 2015 | by Victor Xing | Capital Markets

How do traders and portfolio managers manage risk?

Sell-side traders and buy-side portfolio managers manage risk by keeping accurate mental pictures on asset risk profiles (and their effects on their balance sheet – some risks are additive while others offset) as well as market conditions.

Every asset has risk.  By owning the asset, the risk is transferred onto the trader’s balance sheet.  For example, for every $1,000,000 in 30 year Treasury bonds, a 0.01% yield change would result in a $1971 pnl.  If a client dumps $50mm 30 year Treasury bonds on a trader, the risk, or DV01 (dollar value change per 1 basis point move in yield) would be $98,550.  The trader will need to do the following:

  1. Immediately hedge out the appropriate risk – is the trader bearish in the 30yr sector?  The trader will then have to sell more WN (30 Treasury futures) to hedge out $98,550 DV01 of risk, which will involve selling more than 388 contracts of WNZ5 in the futures market (each contract is $100,000 notional and has a DV01 of 254).  There is no perfect hedge, and the trader is constantly monitoring the WN vs. 30s basis
  2. Slowly let the market digest the $50mm long bond by quietly selling them on the side
  3. The trader’s balance sheet may be already be constrained, and additional bonds need to be sold to make room.  The trader would probably sell some 10 year note and unwind some short positions in TY futures
  4. Very often another client would be calling to do another transaction, step #1 – 3 better be done, because market is moving and time waits for no-one

This gets more complicated by the fact that some clients like to spray bonds all over the street (calling multiple brokers one after another, selling many $50mm pieces).  All the sudden the market is moving, and traders scramble to hedge or get short (manage risk).

But wait, only 2 minutes have passed, and now a Saudi oil minister is speaking on tape.  What?  Keep production high and screw the U.S. shale industry?  Energy stocks are dropping like a stone, and 30 year Treasuries are starting to rally (low energy prices are dis-inflationary).  If the trader had shorted more WN futures than what was required to hedge out the bond risk, say, currently $10,000 DV01 short in the 30yr sector, and the 30yr sector has rallied 2 basis points since the trade, the loss would be $20,000 if the trader didn’t properly manage risk.

By this time, clients would likely be calling to buy 10 year and 30 year sectors due to the news – the trader will try to scoop up 30yr bonds, unwind hedge, and continue to make market.

And that is just an easy couple minutes at work.

Many current and former sell-side bond traders like to say: few on the sell-side has the luxury of owning the attractive bonds, because buy-side institutions would sell them bonds that nobody likes, and bonds that are attractive are quickly bought by clients.  It is a never-ending battle just to manage risk and keeping a close eye on the balance sheet, not to mention every trader has to meet a goal of making X for the bank in order to keep the seat.

Next article11 22 2015 | by Victor Xing | Economics

Does fiscal austerity negate the effectiveness of QE?