Nonsystematic risk should according to academics not count, but dose it count in practice? This is one of the many topics I touch upon in Models on Models: here some of my thought on this subject:
Let us for a moment assume a gold option market maker that has sold a lot of short-term out-of-the-money puts that he is delta hedging. Then suddenly the market is gapping down and down, as we know his delta hedging will not work that well, his losses are increased further by the implied volatility exploding to the upside. He is losing millions and millions and millions and soon blowing through his risk limits. Soon enough he is called into the head of precious metals and commodity trading:
• The Boss: What on earth is going on? You have been blowing through your risk limits, why did you not cover your tails by buying back some of these puts on the way down!
• Market maker: Don’t worry Sir, what I have lost someone else in our bank must for sure have made. When I got hired you specifically told me that the bank is extremely well diversified in all types of markets and businesses. You should thank me for not wasting money on protecting us for unsystematic risk by paying up for those puts. The other banks have been driving up the prices on these put options to unrealistic levels and are clearly not acting rational. Actually my diversification model told me to sell more puts on the way down, and I did. I expect a raise in salary and a good bonus, on aggregate the bank is probably making loads of money, thanks to their well-diversified portfolio and traders like me!
• The Boss: Guards get this nut out of our building now!
Most individuals working as market makers in options are typically only managing a book of options on a few underlying assets. For example, one individual can be a market maker in options on gold and possibly also other precious metals, another market maker on crude oil options, another a market maker in options on Scandinavian currencies and so on. In few if any big banks will you find an individual that is a market maker in a well-diversified portfolio of all types of underlying assets. Further, the currency desk is typically separated from the equity desk, the fixed income desk from the energy desk, etc. (and market makers often also takes considerabely with "calculated" risk)
A large investmentbank as a whole is typically very well diversified and is well aware of the benefits of diversification. If someone loses 50 million on gold options and another trader makes 50 million the same day on some equity option trading, the CEO of the big bank would possibly not even be informed, or at least not worried, she is mainly interested in aggregated trading results. CEO’s are typically not daily decision makers at the trading floor, except for possibly being involved in setting some major risk limits. Inside their risk limits (that can be considerable) traders and market makers rule the trading floors. Sometimes top traders even get paid more than their CEO.
Proprietary traders and market makers in most big Wall Street banks are mainly rewarded in terms of bonus based on the performance in their own portfolio (trading book), and typically only based slightly on overall performance of the whole investment bank. The market maker is an individual and not a computer trying to optimize risk reward for the whole portfolio of the bank. Even on the same small trading desk one trader making lots of money trading in a few underlying assets can get paid several million dollars in bonus while someone sitting next to him/her trading some other assets, but with moderate losses can get zero bonus or even get fired.
Individual traders in general simply do not get paid based on returns from the banks well diversified portfolio, and often not even much on the desk’s performance, but from their own specific trading portfolios. May be they should get paid much more based on the whole of the bank’s performance (and this varies among banks)? This is a completely different discussion, as a trader you have to trade based on how markets are (and how you get paid), not on how some equilibrium model tells you that the market (and bonus system) should be based on a series of strict theoretical assumptions.