The difference between volatility and risk

June 13, 2015

Financial markets often disregard the fundamental difference between volatility (the magnitude of price fluctuations) and risk (the probability and scope of permanent losses). Standard risk management and academic models rely upon volatility alone. Alas, this reliance can induce an illusion of predictability and excessive risk taking. Indeed, low volatility can indicate and even aggravate the risk of outsized permanent losses.

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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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Shadow banking and the backstop problem

February 16, 2014

Modern shadow banking provides large-scale risk transformation services that are highly pro-cyclical (view post here). This is a systemic concern mainly for one reason: most shadow banking activities lack formal transparent backstops, i.e. external risk absorption mechanisms that prevent large negative shocks from escalating.

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How fear of disaster affects financial markets

December 14, 2013

Fear of economic disasters, such as depressions, is more frequent than their actual occurrence. People tend to perceive a growing risk of disaster as they see economic conditions deteriorate. A new Federal Reserve paper illustrates that this pro-cyclicality of fears can trigger fluctuations in equity prices that go well beyond the actual changes in economic conditions, consistent with actual historical experience. Disaster fears also can make asset returns partly predictable.

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A brief history of monetary policy and asset price booms

November 20, 2013

A new NBER paper reminds us of historical episodes when loose monetary policy contributed to asset price booms and busts. The paper also provides econometric evidence that low policy rates usually support asset prices. This history may not dissuade central banks from running highly accommodative policies at present, but explains the importance of accompanying macro-prudential measures.

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A new Asian Crisis?

August 20, 2013

A Nomura research report looks at the rising financial risk premium across Asia. It shows that economic fundamentals are not as bad as they were in 1996. However, Asia’s external surplus has been eroded by a torrid financial expansion, which was fueled by very easy monetary policy. In the absence of a correction of this policy stance, there is an increasing danger that capital outflows will trigger a sudden stop to these accommodative financial conditions.

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Japanese banks’ vulnerability to rising bond yields

July 10, 2013

Standard & Poor’s research suggests that Japanese banks’ government bond holdings and interest rate risks of have almost doubled over the past 10 years. Against the backdrop of more aggressive reflation policies (view here) this translates into a systemic risk. An increase in long-term yields by 200bps compared to 2012 could already impair the banking system. An increase by 300bps or more could spell broadly based challenges for capital adequacy. A concurrent drop in equity would increase the pressure.

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Self-fulfilling tightening and recessions in a low interest rate world

June 23, 2013

A new Bank of England paper points to a dangerous pitfall for monetary policy in a low rates environment. “Speed-limit rules” stipulate that central banks adjust policies in accordance with the change in the economy (e.g. growth, the unemployment rate, or inflation), not its level, in order to avoid policy errors and anchor expectations. At the zero bound these rules can lead to self-fulfilling recessions, as a downshift in (growth and inflation) expectations triggers less hope for policy easing than fears for subsequent tightening (when the initial downshift is being reversed). In my view this dovetails recurrent fears of convexity or jump risk in low-yield bond markets, and may help explaining why global central banks at the zero bound have so far struggled to produce sustained recoveries.

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