Basics of market liquidity risk

January 11, 2015

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.

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Updated Summary: Managing systemic risk

January 1, 2015

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.

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The power of global financial cycles

November 24, 2014
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.

 

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The ECB’s quantitative and qualititative easing

November 13, 2014

The ECB has introduced a set of new policies that emulate quantitative and qualitative easing. Key measures are targeted long-term repo operations, asset-backed securities purchases, and covered bond purchases. The total net balance sheet expansion is expected to be at least 8% of euro area GDP over two years. Additional asset purchase programmes for corporate and sovereign bonds are possible in order to secure sufficient accommodation and to respond to contingencies.

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Self-fulfilling and self-destructing FX carry trades

November 2, 2014

When foreign exchange trading meets inflation-targeting self-fulfilling investment strategies are possible. A technical paper by Plantin and Shin shows that positive FX carry encourages capital inflows that reduce inflation and allow monetary policy to condone a domestic asset market boom. Thereby FX carry strategies create their own implicit subsidy and self-validating flows. Conversely, a reversal of such flows is self-destructing.

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Disaster risk and currency returns

November 1, 2014

A paper by Farhi and Gabaix explains how fear of global crisis leads to outperformance of risky versus less risky currencies. Carry trades have worked historically, because high risk premia conditioned both high interest rates and subsequent revaluation. As a practical conclusion, gaps between perceived risk (often based on historical variances and correlation) and actual fundamental risk (as indicated by fundamental macro factors) are key value generators in FX strategies.

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Updated summary: Shadow banking and asset management

October 26, 2014

Easy monetary conditions and tighter regulation for banks naturally encourage risk transformation and liquidity creation outside the banking system. Institutional asset managers are key agents of that development. As such shadow banking relies on collateral value rather than external backstops it can make the financial system more pro-cyclical and vulnerable. The size and herding incentives of large asset managers could reinforce excesses.

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The pitfalls of emerging markets asset management

October 4, 2014

Dedicated EM exposure has surged by over 55% since 2007, with assets concentrated on few managers. A new BIS article points out that trading flows are correlated due to the widespread use of benchmarks. Moreover, EM asset prices and final investor flows have been pro-cyclical and mutually reinforcing. These patterns seem conducive to recurrent market dislocations.

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When currency strength and credit booms feed on each other

September 6, 2014

A  paper by Bruno and Shin illustrates how global banks drive lending booms in local currency markets. Most importantly, they explain how currency strength fuels rather than curbs financial expansion in small and emerging economies, leading to escalating dynamics. Conversely, dollar strength can trigger a tightening spiral. Empirical evidence seems to support the point.

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The asymmetry of government bond returns

August 31, 2014

Developed market government bonds are viewed as “safe havens”, but in reality they have been prone to sudden outsized price declines, similar to FX carry trades, even during the past 20 years of modest inflation. Drawdowns are worse in poor liquidity. This empirical finding is not new but more relevant as bond yields have been compressed and institutional duration exposure has surged relative to banks’ market making capacity.

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