On “institutional herding”

June 14, 2013

Herding denotes broad uniformity of buying and selling across investors. If the transactions of one institution encourage or reinforce those of another, escalatory dynamics, liquidity problems, and pricing inefficiencies ensue. A Federal Reserve paper (which I noticed belatedly) provides evidence of herding in the U.S. corporate credit market during the 2003-08 boom-bust experience, particularly during sell-offs. Bond herding seems to be stronger than equity herding. Subsequent to herding dynamics price reversals have been prevalent, consistent with the idea of temporary price distortions.

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The limited effect of FX interventions

June 13, 2013

In a new BIS paper K. Miyajima provides evidence that unsterilized FX interventions in emerging market economies fail to influence exchange rate forecasts (as published by Consensus Economics) in the direction of the intervention. This supports the intuition of market practitioners that interventions may briefly stem or reverse the market tide, but do not typically have the purpose or power to change the prevailing fundamental trend.

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The “reach for yield” bias of institutional investors

June 5, 2013

‘Reach for yield’ describes regulated investors’ preference for high-risk assets within the confines of a rule-based risk metric (such as credit ratings or VaR). Bo Becker and Victoria Ivashina provide evidence that U.S. insurance companies act on this principle and show that ”conditional on ratings, insurance portfolios are systematically biased toward higher yield bonds”. ‘Reach for yield’ would be a form of regulatory arbitrage, a source of inefficiency, and a reward for “unaccounted risk” of securities and issuers.

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China’s commodity financing deals

May 27, 2013

Chinese commodity financing deals exemplify how regulation and circumvention can distort more than one major market. These transactions have been a means for circumventing capital controls and facilitated short USD-CNY carry trades. Thereby they generated capital inflows into China, and distorted demand for physical metals (particularly copper) vis-a-vis futures. As China’s State Administration of Foreign Exchange (SAFE) has issued new regulation to curb these transactions, rapid unwinding might cause reverse distortions.

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Quantitative easing and “VaR shocks”

May 19, 2013

Securities held by VaR (Value-at-Risk)-sensitive institutional investors, such as banks, are prone to escalatory selling pressure after an initial shock, in particular if they make up a substantial portion of the portfolio. Nikolaos Panigirtzoglou underscores that the Japanese government bond market has already demonstrated its proclivity to such ‘VaR shocks’. Also on a global scale government bond yields may overtime become more vulnerable, as one of the unintended consequences of quantitative easing.

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Europe’s financial transaction tax and the consequences

April 18, 2013

A recent HSBC report argues that the planned financial transaction tax in the Eurozone will have a profound negative impact on investment returns, as well as on liquidity in cash products and derivatives. The tax is expected to be introduced next year and have broad implication well beyond the countries that have agreed to it.

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Why and when “equity duration” matters

March 23, 2013

A new HSBC report suggests that if and when Quantitative Easing is being reversed it could be a watershed event for sectoral equity performance. Their view is based on the concept of “equity duration”. The long-standing outperformance of low-beta and high-quality stocks, which have longest duration and benefited most from three decades of falling yields, should come to an end and be replaced by relative strength of cyclical, financial and materials stocks.

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Asset overvaluation and bubbles

March 9, 2013

Ever wondered why an asset or asset class maintains an implausibly high price? A new IMF paper summarizes research on “bubbles”, the phenomenon of a lasting overvaluation. It suggests, for example, that the focus on relative performance among asset managers and the presumption of informed decisions by peers causes herding. Also, limited liability of managers and leveraged institutions encourages upside risk taking. Meanwhile, sell-side research, rating agencies, and accountants often lack the incentives to pre-emptively reveal downside risks. Political and institutional aversion to short selling aggravates overvaluation bias.

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Why is volatility so low while uncertainty is still so high?

December 15, 2012

This note from Claudio Irigoyen and others supports the notion that implied volatilities naturally return to long-term trend even if economic uncertainty does not. While implied volatility is very sensitive to deteriorating conditions, actual and implied volatility under poor but stable conditions may be compressed by investor adaptation (defensive repositioning, risk management changes, easing risk aversion, etc.) and policymakers’ direct market intervention (liquidity supply, policy puts, etc.). Technically speaking, the first derivative of economic uncertainty indicators may condition the mean reversion of implied volatility.

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asset management Asset Purchase Program banks bond returns bond yields bubbles capital regulation carry China collateral commodities credit returns default ECB economic data EM equity returns euro area crisis Fed financial crisis FX FX interventions FX returns government debt government deficits herding inflation information insurances Japan leverage liquidity machine learning market turmoil price factors regulation risk management shadow banking statistical methods term structure trend following variance risk premium VIX volatility ZLB
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