The volatility paradox

June 29, 2014

Brunnermeier and Sannikov illustrate in a formal model why fundamental risk and asset market volatility can be out of sync. They focus on endogenous market dynamics, such as “collateral amplification” (the mutual reinforcement of credit conditions and asset values). These endogenous dynamics imply that [i] low-risk environments foster systemic risk, [ii] market reactions to negative fundamental shocks are non-linear (i.e. can become catastrophic when the shock is large) and [iii] financial market risk can de-couple from fundamental risk.

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Understanding capital flow deflection

June 28, 2014

A new academic paper asserts strong empirical evidence for capital flow deflection: one country’s capital inflow restrictions re-direct capital flows to other countries with similar economic characteristics. While the paper investigates from a policymaker angle, it would be relevant for international macro trading strategies.

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The “net stable funding ratio”: a basic briefing

June 22, 2014

The “net stable funding ratio” is a quantitative liquidity standard for regulated banks, scheduled to go into effect in 2018. It will require stable funding sources to be equal or exceed illiquid assets. It may to some degree restrict term transformation of regulated banks and encourage migration into shadow banking. The impact of the new regulation will differ across countries and institutions.

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The idea of uncovered equity parity

May 31, 2014

Uncovered equity parity explains how equity portfolio rebalancing affects exchange rates. Outperformance of foreign stock markets, whether through the exchange rate or stock prices, leaves investors with excess exchange rate exposure. The reduction of this exposure then puts depreciation pressure on the foreign currency. A new Federal Reserve paper presents evidence for the essential parts of that theory.

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A theory of information inefficiency of markets

April 19, 2014

Conventional wisdom is that markets are information efficient. Alas, a simple game-theoretical model illustrates that value traders only have an incentive to invest in research and information if (i) information cost is low enough, (ii) the overall market is sufficiently clueless, and (iii) market makers do not suspect value traders of being well informed. This leaves ample scope for the overall market to remain inefficient, even in the long run, with undesirable consequences for society as a whole.

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An overview of financial crisis theories

March 29, 2014

Daniel Detzer and Hansjoerg Herr deliver a superb summary of timeless economic theories of financial crisis. The main focus is on (i) escalatory inflation and deflation dynamics caused by monetary policy, (ii) boom and bust investment cycles caused by herding and inefficient expectation formation, and (iii) speculative bubbles related to cognitive behaviour that is inconsistent with efficient markets.

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How Fed asset purchases reduce yield term premia

February 15, 2014

An updated Federal Reserve paper suggests that there has long been a link between the net supply of government securities and term premia on Treasury yields. A 1%-point reduction in the ratio of Treasuries or MBS (10-year equivalent) to GDP supposedly reduced the 10-year term premium by 10 basis points. A one-year shortening of the average effective duration would lower the ten-year Treasury yield by about 7 basis points. Based on these estimates, the 2008-2011 large scale asset purchase and maturity extension programs of the Federal Reserve could have reduced the 10-year term premium by a total of 150 basis points.

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Herding in financial markets

February 1, 2014

Herding is a deliberate decision to imitate the actions of others. In financial markets with private information herding can be efficient for an individual asset manager, but increases the risks that the market as a whole is inefficient and fragile, particularly in the case of “information cascades”. A paper of Michael McAleer and Kim Randalj provides empirical evidence of herding in a range of futures markets.

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Volatility insurance and exchange rate predictability

January 26, 2014

The cost of insuring against currency volatility can be measured as the difference between (options-based) implied volatility and (swaps-based) forward expected realized volatility. A case can be made that this insurance premium determines how much exposure risk-averse institutions are willing to accept. A new paper and blog post by Della Corte, Ramadorai, and Sarno claim that variations in volatility insurance costs can be the basis for a profitable currency trading strategy.

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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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