Headline risk is the risk of a negative impact on the value of a company, as reflected by its stock price and other publicly traded instruments associated with the company. It also refers to the damage to the core business due to a loss in reputation caused by a news piece.
The risk is not limited to individual businesses and can impact the market as a whole. It also impacts investors as it can cause unprecedented drawdowns, especially in concentrated or levered portfolios.
Headline risk is exacerbated by other effects like the bandwagon effect. Under the bandwagon effect, a critical mass of people acting in a similar fashion grows very fast as people imitate the crowd and make the same decision.
A common example of headline risk is the case of an acquisition. When a company announces an acquisition of another company, it is reflected in the stock prices of both companies. The price of the acquirer decreases, and the price of the company being acquired increases. It is a classic merger arbitrage opportunity.
In case there is a false report of an acquisition, the prices will move as described above. It will affect the portfolio of an investor for no fundamental change in the value of their holdings. The change here is caused purely by the false headline. Such rapid changes can even cause permanent damage to a highly leveraged portfolio.
Headline Risk in the Internet Age
In the internet age, any negative news can spread very fast. It is further exacerbated by the rise of electronic and high-frequency trading. The reaction to any news is almost instantaneous and extreme given the speed at which assets can be traded.
Further, given the nature of modern search engines, a bad news story can quickly become associated with a company. It can tarnish the company’s reputation, which can lead to loss of business opportunities in the future. The next sections discuss two cases of headline risk and a hedge fund strategy that relies on the news.
The most recent example of headline risk is the case of Twitter Inc. On October 29, 2020, the price of Twitter (TWTR) stock fell by as much as 20% due to a news report about slower-than-expected user growth. It was an extreme move by all measures that would’ve caused unprecedented drawdowns within a single trading day. The following chart shows the price of Twitter over the last three months:
The Associated Press Panic
In April 2013, a false news report about an explosion at the White House injuring the then-President Barack Obama caused a brief but short panic in the market. The report came out via the Twitter account of the Associated Press, which is a reputed news service.
The reaction was quick, and the market dropped sharply, but it recovered it as fast as it crashed. It was a pure headline risk that impacted the entire market. Such volatility can wipe out investors and lead to wild mispricing in the stock market, as well as the derivatives market.
Several investing strategies specifically exploit the price movement in the market due to corporate events like mergers, earnings calls, bankruptcies, etc. Hedge funds using an event-driven strategy track the news and developments for individual companies using company documents, as well as through their network within the investment banking that carry out the transactions. Such event-driven strategies are highly susceptible to headline risk as these hedge funds build their positions carefully after intensive research.
Any unfavorable headline can undo gains from months of research. On the other hand, the funds make most of their gains on the days that corporate events are announced. Hence, the investment strategies are highly sensitive to headlines and other news items, i.e., they come with high headline risk.
Managing Headline Risk
Unlike financial risks, headline risk is unquantifiable. Traditional risk management measures, like Value at Risk (VaR) are not applicable. Different actors need to manage headline risk in their own way. A company may do it by employing an effective public relations department that can rapidly get the company’s point of view out to the press and the public. In fact, most corporations invest heavily in improving their public image. A good public reputation can help a business recover from unforeseen headline risk.
Investors can protect their portfolios in more traditional ways like using put options, but there is no way for investors to time their hedges. Since headline risk cannot be quantified, there are limited hedging techniques that can be used.
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