The growing concerns over market liquidity

November 7, 2015

Market liquidity accommodates securities transactions in size and at low cost. When it fails the information value of market quotes is compromised, potentially triggering feedback loops, margin calls and fire sales. With shrinking market making capacity at banks, the fragility of liquidity in both developed and emerging markets has probably increased. The rise of larger and more pro-cyclical buy-side institutions seems to enhance this vulnerability.

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Why decision makers are unprepared for crises

September 13, 2015

An ECB working paper explains formally why senior decision makers are unprepared for crises: they can only process limited quantities of information and rationally pay attention to rare events only if losses from unpreparedness seem more than inversely proportionate to their rarity. The less probable a negative event, the higher the condoned loss. Inattention gets worse when managers bear only limited liability.

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Liquidity events

August 16, 2015

A recent speech by Fed governor Jerome Powell highlights recurrent episodes of short-term distress and vanishing liquidity in large developed markets. Increases in trading speed, market concentration, and regulatory costs of market making all may be contributing to these liquidity events.

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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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How statistical risk models increase financial crisis risk

June 14, 2014

Regulators and financial institutions rely on statistical models to assess market risk. Alas, a new Federal Reserve paper shows that risk models are prone to creating confusion when they are needed most: in financial crises. Acceptable performance and convergence of risk models in normal times can lull the financial system into a false sense of reliability that transforms into model divergence and disarray when troubles arise.

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Concerns over risk parity trading strategies

August 29, 2013

Risk parity portfolios allocate equal risk budgets to different assets or asset classes, most frequently equities and bonds. Over the past 30 years these strategies have outperformed traditional portfolios and become vastly popular. But a recent Commerzbank paper shows that outperformance does not hold for a very long (80 year) horizon, neither in terms of absolute returns, nor Sharpe ratios. In particular risk parity seems to be performing poorly in an environment of rising bond yields. And levered risk parity portfolios (“long-long trades”) are subject to considerable tail risk.

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Why CDS spreads can decouple from fundamentals

July 16, 2013

A Bundesbank working paper provides evidence that Credit Default Swap (CDS) spreads change significantly in accordance with (i) the direction of order flows, (ii) the size of transactions, and (iii) the type of counterparty. Apparent causes are asymmetric information, inventory risk and market power. The implication is powerful. Since transactions do not require commensurate changes in fundamentals and since CDS spreads are themselves used for risk management, institutional order flows can easily establish escalatory dynamics.

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The structural rise in cross-asset correlation

June 20, 2013

Cross-asset correlation has remained high in recent years, despite the post-crisis decrease in volatility. Typically, correlation surges during financial crises, when macro risk factors dominate across markets. However, J.P. Morgan’s Marko Kolanovic and Bram Kaplan show that there has also been a secular increase in cross-asset correlation since 1990, due probably to globalization of markets, risk management and alpha generation techniques.

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Measuring diversification and downside risk

June 1, 2013

Deutsche Bank’s Handbook of Portfolio Construction gives a great introduction to two important principles for diversification and risk management of portfolios. First, tail dependence is a better guide to diversification than correlation when it really matters, i.e. in market turmoil. Second, conditional Value-at-Risk concepts (CVaR) estimates average losses one may sustain in an extreme event, and hence should be more representative for true downside risk than standard VaR. Backtests suggest that portfolio construction based on these and other risk measures produces signficant investor value.

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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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Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for two decades. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.

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