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  • Writer's pictureWilliam Webster

A political measure

Updated: Jan 15

Just before the big vote few people expected the UK to opt out of the EU. If you believe that markets are, by and large efficient, the small risk of Brexit was priced in albeit with a low probability. However because of a yes/no decision the unexpected vote makes larger waves. Something traders call gamma risk. It’s a problem because it’s almost impossible to hedge. It also means that normal models (deltas, VaR etc) don’t fully describe your downside (or upside) potential. Political risk is something for which they aren’t designed. In a world of low growth, as capital and labour fights for a bigger slice of pie this risk is magnified. It’s therefore appropriate to ask how you capture it. The standard approach is scenario or stress testing. The problem is that often the picture painted isn’t one of political disruption. It’s more a “what-if” based on moderate volatility. A more instructive approach would be to consider why turmoil occurs and what it can do. Good places to start would be 19th November 1967, 18th October 1987, 16th September 1992 for longer periods consider 1987-1993. This will look ugly. But it helps you understand two things. What courses of action can you take? And Is your business balanced? If like me you think politics are back it’s a worthwhile exercise.

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