Directional vs Non-Directional Risk

[PDEM200]

Hello David,
Could you please provide some additional details/examples about directional vs non-directional risk? I am a bit confused about listing interest rate risk as a directional risk (eg convexity-which is not linear and therefore non-directional?). Appreciate your thoughts.thks

 

[David Harper CFA FRM]

Hi Paul,

The directional/non directional distinction sources from merely 2 sentences in Jorion Ch 1. I personally don't love it (but, hey, i just work here).
I may not myself understand but when he refers to non directional as including non-linear, well, i am confused by that too; e.g., althought common factor exposure to say currency or interest rate may often by modeled as linear, clearly that isn't necessarily the case...

It *reminds* me of the "directional" designation used to categorize certain hedge fund strategies; equity long/short because such a strategy is intentionally long some (common) market exposure (beta > 0). Compared to a "non directional" strategy like equity market-neutral which seeks zero common market factor exposure.

So i think by directional he simply means that your instrument/portfolio is exposed to the (directional) movement in some (pubic) common factor; e.g., market return, interest rate. I agree with your implication, if i understand it, that directional and non-directional, defined this way, can commingle in a position (which is consistent with Jorion's theme of typing different risks but emphasizing their interdependence).

So, the equity long/short portfolio has a directional component (i.e., exposure to direction in overall market) plus some "hedged" positions that, e.g., are counting on convergence. (I don't love it also because he slots volatility in non-directional; it seems to me a typical option portfoio commingles common factor "directional" volatility exposure plus idiosyncratic...)

I think the idea with convexity is: convexity itself favors the long bond regardless of whether the rate moves up or down (the convexity adjustment is always positive), so the convexity itself is not a directional bet. So, a typical bond portfolio, under Jorion's definition, would appear to contain both directional and non-directional risks. I interpret Jorion's definition here as implying that duration is a directional risk (long bond: interest rate up is bad for me) and convexity as non-directional (a function not of a common factor, but properties of the bond)

David

 

[Hardy Noman]

1. Directional risks are those risks where the loss arises from an exposure to the particular assets of a market. For e.g. an investor holding some shares experience a loss when the market price of those shares falls down.
2. Non-Directional risk arises where the method of trading is not consistently followed by the trader. For e.g. the dealer will buy and sell the share simultaneously to mitigate the risk