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Types of Investment Risk: Jump/Event Risk

We are in the middle of a series breaking down the various types of investment risks. You can read the introduction here. We are posting one article covering one risk each weekday until the series is complete.

Yesterday we covered , and today we are covering...

Risk #13: Jump/Event Risk

Description: When market volatility spikes or other major market swings affect particular investments, this is called "jump" or "event" risk. This risk particularly affects investments with a high amount of leverage or hedging activity that is dependent on an assumption of lower volatility.

S&P 500 Volatility

Primarily Applies to... Derivatives, highly leveraged investments, hedged investments, margin accounts, insurance contracts that have triggers and out clauses based on major market divergences/disruptions.

Real World Examples: The Lehman crisis in part was fueled by jump risk on default swaps/insurance far outside of the bounds of their range of expectations. AIG also crashed because it vastly underestimated the likelihood of certain payout events.

Extreme Avoidance Measures: Steer clear of highly leveraged investments or hedges or companies whose primary business is in thin-margin default insurance and counterparty trades. Avoid investments that have a lot of leverage and that depend on lower interest rates to make their business profitable.

Potential Mitigations: Avoid any investment that is dependent on low volatility in any particular market to be successful. Though volatility can be suppressed for a period, it cannot be suppressed forever--the eventual volatility that arises tends to more than make up for all of the volatility that was suppressed in the preceding period, wreaking havoc on all the parties that depended on volatility staying unnaturally low for an extended period. This is particularly difficult since we are not aware of all of our market assumptions; no one even considered the housing market could drop much more than 10% in value before the housing crisis - it was not even part of the discussion.

Stay tuned, tomorrow's highlighted risk is: Operator/Management Risk.