Basics of market liquidity risk

Market liquidity measures the cost efficiency of trading. Liquidity risk refers to the probability that these costs surge when trading is required. Liquidity and liquidity risk are major factors in the long-term performance of trading strategies. The apparent inverse relation between liquidity and expected returns also offers obvious profit opportunities. There are various conceptual solutions for measuring market liquidity timely.

(more…)

Falling oil prices and the risk for zero-rate economies

A Bank of Italy paper illustrates the detrimental effect of a “negative cost push shock” (for example a commodity price drop) on an economy with low inflation and interest rates close to zero (such as the euro area). In normal times a downside cost shock would boost output. At the zero lower bound for rates, however, it would trigger a contraction, due to rising real rates and debt service.

(more…)

Updated Summary: Managing systemic risk

Explicit management and research of systemic risk is critical for macro trading. First, it supports timely risk reduction or, alternatively, avoidance of uninformed mechanical liquidations. Second, the calibration of tail risk gives a better idea of value-at-risk. Third, systemic risk research helps the efficient and profitable trading of options and credit default swaps. And fourth, know-how of systemic risk is a valuable currency for information exchange within the investment community.

(more…)

Variance risk premiums, volatility and FX returns

Variance risk premiums mark the difference between implied (future) and past volatility. They indicate changes in risk aversion or uncertainty. As these changes may differ or have different implications across countries, they may cause FX overshooting and payback. The effect complements the simpler argument that rising currency volatility predicts lower FX carry returns. Academic papers support both effects empirically.

(more…)

Information inattentiveness of financial markets

Academic research explains macroeconomic information inefficiency with “stickiness” and “signal extraction problems”. Information stickiness means that forecasts cannot be updated continuously and hence markets partly operate on outdated information. Signal extraction problem means that forecasters struggle to separate noise from signal in economic data. The consequence is rational “inattentiveness” of financial markets, offering profit opportunities to those that analyze economic data timely and efficiently.

(more…)

Bond market liquidity risks

A new CGFS study suggests that [i] bond market makers’ risk tolerance and warehousing have declined and [ii] tighter risk management has augmented pro-cyclicality of liquidity. A gap seems to have opened between more precarious liquidity supply and more voracious liquidity demand, due to rising assets under management at funds that allow daily redemptions.

(more…)

Updated summary: Government finances and systemic risk

With public debt ratios at their highest levels in two centuries, financial repression has become inevitable, representing the single viable alternative to default. Moreover, global fiscal tightening is still far from complete. Fiscal restriction will probably diminish in coming years if economic growth is exceeding real interest rates, but may come back with a vengeance if not.

(more…)

The dangerous slide in global real interest rates

Various research contributions suggest that the global decline in real interest rates may be self-reinforcing. That is because low real rates spur leverage, debt, and resource misallocations. This gradually lowers the natural rate of interest of the economy. Yet when the natural rate falls, the policy-influenced actual real rate must fall alongside, merely to avoid a tightening of financial conditions. At the zero lower bound this can lead to distress.

(more…)

Size, risks and regulation of shadow banking

Recent FSB reports give an updated assessment of shadow banking. Non-bank financial intermediation in its broadest definition is estimated to be 120% of global GDP and growing. Its expansion is dependent on market prices for collateral. Dislocations can be contagious for banks. Regulatory policies may mitigate pro-cyclicality and contagion, but only modestly so.

(more…)

The power of global financial cycles

There is theoretical reason and empirical evidence for a single global financial cycle driving capital flows across a wide range of markets. Federal Reserve decisions are one major cause for this cycle, challenging the independence of monetary policy elsewhere. Catalysts of financial cycles are leveraged investors with Value-at-Risk constraints, such as banks.  One consequence is correlated risk across a wide range of leveraged investment strategies.

 

(more…)