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Updated Summary: Managing systemic risk

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.

The below is an update of the summary page “Managing systemic risk” of this blog.
It is based on a number of posts, with the links given below.
Further research and thoughts on this subject would be highly appreciated (rjsueppel@gmail.com

The management of systemic risk is of paramount importance for social and investor value created by modern portfolio management.

  • From a social angle, there is evidence of boom and bust investment cycles caused by herding, inefficient expectation formation, and speculative bubbles related to cognitive behavior that is inconsistent with efficient markets (view post here). There is also evidence for a single global financial cycle driving capital flows across a wide range of markets, the catalyst of which appears to be model-based risk management of banks and other financial institutions (view post here).
  • From an investment angle, the majority of  strategies are some combination of directional market exposure and relative value, managed by Value-at-Risk estimates. Systemic crises typically derail all of these. That is because in contrast to normal market drawdowns, systemic pressures trigger mass forced position liquidations, due to funding, accounting or legal constraints, often with no freedom of choice for portfolio managers. Hence, in systemic events the principles of sensible positioning or flows may not only be suspended but reverse with the best-value position (by conventional standards) posting the greatest loss at great speed and size

It is therefore clear that investment managers’ research and monitoring of key systemic risks is crucial for long-term value generation. There are at least four strategies for unlocking the systematic value of systemic risk research:

Managing portfolio risk

Researching systemic risk helps preparing for crises, either by increasing the chances of early portfolio adjustment or by avoiding panic and risk management-driven liquidation in tight liquidity with inordinate transaction costs.

  • Early portfolio adjustment: It is practically impossible to predict systemic crisis. However, it is possible to understand the nature of vulnerability in economies and markets. Through research in this field, asset managers can judge whether a specific shock is likely to be transitory or escalatory. For example, economies that are accustomed to low real interest rates could face escalatory dynamics when rates or credit spreads are rising. However, they are more likely to face transitory stress as long as there is a credible option of government or central bank intervention (view post here).
  • Avoiding expensive liquidations: Liquidity is tight in systemic crises, making position adjustments sometime prohibitively expensive. If anything, structural and regulatory changes in recent years have made liquidity more precarious than in the past (view post here). Hence, calibrating or structuring positions such as to withstand liquidity events can be a major cost saver and performance factor. Researching the nature and potential of systemic risk is critical, both for preparation and for judgment, whether or not it is really in the investor interest to liquidate positions in the thick of crises.

Calibrating tail risk

In the past, standard risk management techniques did not regularly account for such “tail events” and “gap risk”. For example, diversification and downside risk analyses that rely on Pearson correlation and Value-at-Risk conveniently assume normal probability distributions and give little weight to large outliers. By now this “normality assumption” has been widely refuted and better gauges of tail risk are available can serve risk management (view post here). Applying tail risk management in good faith directly benefits investors and is indispensable for broad financial stability.

Pricing insurance premiums

In some markets, escalatory risk, such as systemic financial crises, can be priced through credit and option premiums (view post here). This can prevent excesses. For example, if credit default and option protection is becoming more expensive, real money flows into affected securities will be constrained and the cost of unsustainable policies or regimes will become obvious relatively early. Hence, from an investor value perspective researching systemic risk and locking in appropriate premiums is profitable. And from a social value perspective the guidance of financial flows based on these premiums reduces the risk of imbalances.

Information exchange

No single investor or institution has all pieces of the puzzle that is systemic risk. Investors specialize on markets or countries. However, every financial market depends on all other markets and their conditions. This is due largely to the importance of global liquidity, the ease of financing transmitted by a small number of financial centers (view post here).

Therefore, investment managers should engage in active information exchange, trading their insights for the insights of colleagues. This creates investor value, because these investment managers are better positioned to act early, as they know more and know better what others know. From a social welfare angle this process of information exchange is essential to disseminate concerns over systemic crises. The dissemination turn may serve to warn market participants, policymakers, and the broader public.


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