What is going on? We are racing towards Greece’s repayment deadline at the end of the month, yet there are distressing indications of complacency. There are signs that investors interpret their own pre-positioning and the relative calm in the global markets as a licence to sit back and watch, rather than undertake a continuing analysis of the specific risks they might face on the occurrence of particular outcomes.
The global markets may have priced the risk in, may view any negative outcome as likely to be relatively self-contained, may believe that the IMF will not seriously tolerate a relatively small £1.5bn debt default as a trigger for events with far-reaching and long-lasting consequences and/or may believe that the IMF will win the game of brinksmanship currently being played out, but does this mean we all then sit back and watch?
In his recent article on 28 May, “Market calm on Grexit an eerie recall of pre-Lehmans bets”, Reuters Chief Markets Correspondent, Jamie McGeever observed this “relative calm” in the global markets while the latest act in the Greek debt crisis plays out. Citing the VIX index - a measure of the implied volatility of S&P 500 options - McGeever noted that it was “last hovering around 13, close to its historic low, and sharply down from the 50-mark reached when the euro zone debt crisis reached boiling point in 2011”.
More than two weeks on from that article and that much closer to the repayment deadline, and despite the best efforts of the press to whip up a storm, at the close on 16 June the FTSE 100 closed flat, while the Dax and the Cac 40 both closed marginally up. The VIX was still at the low end in the 14.81 - 15.62 range, still not suggesting alarm or a spike in fear of increased volatility (its 52 week range is 10.28 - 31.06). There may of course be increased volatility as we move closer to the repayment deadline, but the point, simply, is how best should we use our time during this period of “relative calm”?
If recent history teaches us anything, it is that there was similar relative calm – measured by VIX levels - and complacency during the period that preceded Lehman’s filing for bankruptcy protection – a period when the generally held view was that Lehman would not be allowed to fail. A recurring theme amongst hedge funds directly affected by the Lehman collapse was that there was little detailed risk analysis, let alone risk mitigation steps taken, until it was all too late.
As we wait on Greece, the relative calm should not preclude or encourage abdication of ongoing analysis of the specific risks an investor might face. After all, there is no foregone conclusion and a hedge fund manager’s duty to appropriately manage the hedge fund extends not only to a view of the market, but to understanding, assessing and weighing the universe of risks the fund may be exposed to.
There are numerous legal memoranda circulating in the market relaying the labyrinthine complexities of a Greek default or euro exit, but there are specific fact patterns which can nevertheless be considered. Take, for example, the possibility of redenomination. Whether a swap counterparty pays through EUR or new currency on unwind, the hedge fund is exposed to FX risk, but the different points at which that FX exposure is crystallised may be what’s actually important. Another example. Where a Greek security the fund is exposed to is redenominated, the resulting FX exposure to the hedge fund may be negative - or even positive - depending on which side of the market the hedge fund is on, e.g. on unwind sell EUR/buy new currency to close out short vs. buy EUR/sell new currency to repay the EUR debit balance on a margined long position.
Now, during this waiting period, is the time to undertake a rigorous appraisal of the risks the fund is exposed to.