What lessons does GameStop have for Finance Directors?
By some distance, the most remarkable story in financial markets in January was that of GameStop, a loss-making video game retailer that saw its market cap soar from $1b in December to over $30b before the end of the month. In a wildly successful attempt by retail traders to target Melvin Capital, their coordinated action on online message boards drove up the share price after the hedge fund disclosed its short position on GameStop. Blind-sided by the price action in GameStop, Melvin Capital ended up losing 53% in January and required a capital injection of $2.75b from investors to survive and other hedge funds with similar strategies have been forced to reflect on their own risk management strategies.
Extreme price action like we witnessed in the GameStop share price have been previously coined “black swan” or “6-sigma” events but these metaphors have become somewhat hackneyed given that purportedly 1 in 10,000 year events happen every couple of years. The reality is more prosaic and a more likely explanation is that even sophisticated market participants like hedge funds misprice the risk around low probability events, known as tail risks, incorrectly. To use a simplified example, Melvin Capital forecast it would return a profit of $0.89 on its short position on GameStop by projecting a 99% chance of GameStop trading lower, for a $1 gain and a 1% chance of GameStop trading higher with a $10 loss. With the benefit of hindsight, while the probability of a higher share price was still just 1%, a more accurate projected outcome should have been closer to a loss of $5,000 than $10!
Which brings us to risk management for corporates. Financial markets are in a strange place currently. Equity markets, especially in the US, are by some measures in bubble territory and with more than $17 trillion of bonds trading at negative interest rates, the same could easily be said of bond markets. Global debt levels have hit new records and are more than 25% above levels that triggered the global financial crisis. Assets at major central banks have increased from $5 trillion to $30t since the last financial crisis and currencies are being debased to fund this growth. Yet markets, hooked on central bank support, remain remarkably calm with leading crisis indicators such as a strengthening dollar, a spike in the VIX index or widening credit spreads becalmed. Many commentators remain confident that markets will remain buoyant in 2021.
But what if they’re wrong? What if we are Melvin Capital and this is December? For Melvin Capital, the losses were catastrophic but could have been contained had they an effective strategy to stem losses. That the catalyst for the loss was a reddit message board was unexpected and, in many ways, irrelevant. Similarly, firms carrying debt should not be concerned with trying to work out if interest rates will rise or where the catalyst for higher interest rates will emerge from but rather focus on the impact higher interest rates would have on their cash flows and covenants and, if material, work to mitigate the impact.
With interest rates at historical lows and forward curves flat, hedging interest rate risk is cheap and reduces your exposure to the randomness of financial markets. Melvin missed its opportunity to mitigate its financial risks. Don’t be like Melvin.