Extreme volatility significantly increases the probability of receiving a margin call. Ron Bewley explains
If there is one thing investors have learned from the recent bear market, it is that there is much truth behind the statement that “gearing amplifies risk as well as returns”. Not just because the market has gone down, but because of the speed, at times, at which it has done so. Even if we allow for zero or positive underlying growth in market prices, volatility in markets can cause a margin call. The greater the volatility, the greater the probability of a margin call. As the portfolio value falls, the loan-to-value ratio (LVR) goes up, making the starting point for a margin call that much closer. This fall, combined with extreme volatility, makes a dangerous cocktail. Therefore, during such times, it is important that investors pre-emptively adjust their LVRs to reduce their chance of receiving a margin call. Before the current crisis began, most seasoned geared investors would have had some notion of the LVR at which they felt relaxed, and another, higher LVR at which they would have become alarmed and felt it time to take action – either by selling down part of the portfolio or by adding more security. Having such “reference LVRs” in mind can lead to less stress and less risk. So if investors had such reference LVRs, the question they now need to ask is, should these be adjusted, now that volatility is higher?
To answer this question we look at an example. Let’s assume an investor has a geared portfolio with a maximum LVR of 70 per cent and a 10 per cent buffer. We also assume that this investor used to be content with gearing to a level of 50 per cent and would typically become concerned – and usually take action – when their LVR reached 65 per cent. By “used to be” we mean before the current crisis (July 2007), when market volatility averaged, say, 15 per cent. Before we go further, it’s important to note that although long-run volatility may be at a particular level, say 15 per cent, there will always be clusters which are short, sharp bursts of increased volatility. And it is for this reason that an investor should consider the notion of an “alarm LVR” that could be reached during such times. However, it is also important for clusters to be distinguished from changes in the long-run level, which is what we’ve seen recently.
At their “comfort LVR” (50 per cent) the investor can take a 38 per cent fall in the value of their portfolio before receiving a margin call, while at their alarm LVR (65 per cent) the portfolio can fall 19 per cent before a margin call will be made. The investor’s actual LVR is now 68 per cent – a level above their comfort LVR and alarm LVR – since the portfolio has lost value over the last year or so. This means that if they don’t take any action, a further fall of 15 per cent will trigger a margin call. It’s relatively simple to work out the fall required for a margin call at various LVRs, as we’ve just done. But what’s less straightforward is assessing the likelihood that such a fall will occur – that is, the probability of a margin call. We make assumptions regarding the distribution of portfolio returns and use a technique called simulation to estimate these probabilities.
First we do this assuming “normal” volatility – that is, the 15 per cent per annum which was typical for the investor’s portfolio before the crisis. We then repeat the exercise under “extreme” volatility, which in this case we consider to be about 30 per cent per annum. While this has been the average since the crisis started back in July 2007, the jury’s still out on whether this period is now behind us, with volatility in recent months consistently below this level. We calculate that for a period of one month, at their current LVR of 68 per cent, the investor’s chance of a margin call jumps from 2.3 per cent under normal volatility to 20.0 per cent under extreme volatility – a level which is hopefully much too high for nearly all investors to tolerate.
At the investor’s old comfort LVR of 50 per cent, the calculated probability of a margin call within a month increases from almost zero to a one-in-250 chance when volatility is extreme. And at the alarm LVR, the probability increases from 0.8 per cent to 11.1 per cent. So how can the investor adjust these benchmark LVRs to compensate? Essentially, what they should try and ensure is that, even though volatility is now higher, they are facing the same chance of a margin call as they were before. To do this, they’ll need to reduce their actual LVR as well as their comfort and alarm LVRs. For example, in this case, to ensure the same level of comfort, the investor should reduce their comfort LVR from 50 per cent to 30 per cent, now that volatility is extreme. And to have a feeling of alarm that’s equivalent to what was felt at an LVR of 65 per cent, the investor should reduce their alarm LVR to 52 per cent.
So while volatility now might be significantly higher than when many investors first entered the market, a geared strategy can still be viable – and could prove rewarding when the market turns – provided LVRs are adjusted and managed appropriately. Remember: Risk management comes first, returns second.
