Systemic Liquidity Risk and Bipolar Markets E-Book

Clive M. Corcoran

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Bloomberg (UK)
• Sprache: Englisch

Seitenzahl: 809

Veröffentlichungsjahr: 2012

Beschreibung

The dramatic and well chronicled crisis of 2007/8 marked a watershed moment for all stakeholders in global capital markets. In the aftermath, financial markets have become even more tightly coupled as correlations in returns across multiple asset classes have been at historically elevated levels. Investors and fund managers are, to a much larger degree than previously and often much more than they realize, subject to the risk of severe wealth destruction. The ultimate hazard, which is not adequately characterized by the widely touted notion of tail risk, is the systemic risk which arises when liquidity in markets completely evaporates.  Not only did this happen in the second half of 2008, but it has been repeated episodically since then – most notably in May 2010, in an incident known as the Flash Crash, and in the fall of 2011 when correlations were at historically elevated levels.

Conventional asset allocation tools and techniques have failed to keep apace with the changing financial landscape which has emerged since 2008. In addition to the preponderance of algorithmic trading and the associated changes in the liquidity characteristics of financial markets, a new paradigm of risk on/risk off asset allocation has emerged.  Risk on/risk off is a widely adopted style of trading and macro allocation strategy where positions are taken in several closely aligned asset classes depending on the prevailing sentiment or appetite for risk.  The consequences of the day to day (and intraday) switching between either a risk on or risk off tactical strategies poses significant new challenges to investors who are still making investment decisions with outmoded notions from traditional asset allocation theory.

How can one cushion the impact of systemically threatening events when the ability to exit financial instruments becomes almost non existent? How can one trust the integrity of financial models and orthodox macro financial theory which have become increasingly discredited? Can central bankers be relied upon to become the counter-parties of last resort and provide a safety net under the financial system?  These vital questions, and many others, need to be addressed by everyone who has a stake in modern financial markets, and they are addressed in Systemic Liquidity Risk and Bipolar Markets.

Proper functioning markets require fractiousness or divided opinion, and this needs to be lubricated by communications from central bankers, economic forecasters, corporate executives and so on. As long as such messages and market conditions remain ambiguous, providing asymmetric information to different market players, then the conditions are present to enable systemic liquidity to be preserved. Seen in this context the prevailing paradigm of bipolar risk on/risk off asset allocations is both a prerequisite to liquid markets, and also paradoxically, when one side of the polarity becomes too extreme, a major source of systemic instability.  Should such polarities become critically unbalanced, and should the signals received by market players become symmetrically disadvantageous as they were in the fall of 2008, then an even more substantial systemic liquidity crisis than that seen in those troubled times is a dangerous possibility. 

Apart from the practical risk management tools and tactics that are recommended in Systemic Liquidity Risk and Bipolar Markets, there is a provocative and cogent narrative to provide anxious and perplexed investors with a coherent explanation of the post GFC financial environment, and which should assist them in navigating the choppy waters ahead.

Leseprobe

Contents

Cover

Series

Title Page

Copyright

Foreword

ACKNOWLEDGEMENTS

Chapter 1: Introduction

1.1 HOW HELPFUL IS THE NOTION OF TAIL RISK?

1.2 DICHOTOMIES AND AMBIGUITIES

1.3 TRUST AND SOLVENCY ARE ALL OR NOTHING DICHOTOMIES

1.4 THE ASYMMETRY OF PRIVATE GAIN AND PUBLIC LOSSES

ENDNOTES

Chapter 2: Cross-Sectional Asset Correlations

2.1 LESSONS FOR RISK MANAGEMENT

2.2 CORRELATIONS AND VOLATILITY

2.3 INCREASED ASSET CORRELATIONS

2.4 STRESS REGRESSION ANALYSIS

2.5 HEAT MAPS ILLUSTRATE THE BINARY NATURE OF RISK ON/RISK OFF

ENDNOTES

Chapter 3: The Changing Character of Financial Markets

3.1 MARKET RETURNS DO EXHIBIT MEMORY

3.2 HURST COEFFICIENT

3.3 HURST VALUES REACHED EXTREMES DURING 2008

ENDNOTES

Chapter 4: The Flash Crash

4.1 MARKET MICROSTRUCTURE

4.2 PREDATOR PREY DYNAMICS

4.3 COMPUTER SIMULATIONS OF MARKET BEHAVIOR

ENDNOTES

Chapter 5: Detecting Mini Bubbles with the VPIN Metric

5.1 ADVERSE SELECTION AS THE BASIS FOR THE VPIN METHOD

5.2 THE ROLE OF THE JAPANESE YEN IN THE FLASH CRASH

ENDNOTES

Chapter 6: Foreign Exchange and the Carry Trade

6.1 PRIMER ON THE FOREX MARKET

6.2 THE FX CARRY TRADE

6.3 DOES THE CARRY TRADE POSE A RISK TO THE FINANCIAL SYSTEM?

ENDNOTES

Chapter 7: The Enigmatic Performance of the Japanese Yen

7.1 THE NIKKEI 225 AND THE YIELD ON THE US TREASURY TEN-YEAR NOTE

ENDNOTES

Chapter 8: The Aussie/Yen Connection

8.1 THE ROLE OF AUSSIE/YEN IN INTER-MARKET STRATEGIES

ENDNOTES

Chapter 9: Precursors to Illiquidity

9.1 USING HEAT MAPS FOR FX AND OTHER ASSET CORRELATIONS

ENDNOTES

Chapter 10: Mainstream Financial Economics Groping Towards a New Paradigm

10.1 DISAPPEARANCE OF INCOME

10.2 VENDOR FINANCING

10.3 GLOBAL IMBALANCES AND THE MARTIN WOLF THESIS

10.4 PROJECT EVALUATION AND THE COST OF CAPITAL

10.5 TOWARDS A NEW PARADIGM IN ECONOMIC THINKING

10.6 RATIONAL AND EFFICIENT MARKETS

ENDNOTES

Chapter 11: Could a Eurozone Breakup Trigger Another Systemic Crisis?

11.1 THE EUROPEAN STABILITY MECHANISM (ESM)

11.2 IMPACT OF MONETARY UNION

11.3 THE DEBT DEFLATION TRAP IN THE EUROZONE

11.4 EUROBONDS

11.5 THE VISCERAL DIMENSION TO THE EUROZONE’S PROBLEMS

ENDNOTES

Chapter 12: China, Commodities, and the Global Growth Narrative

12.1 CHINESE CONSUMPTION OF BASE METALS

12.2 THE INTERNATIONALIZATION OF THE RENMINBI

ENDNOTES

Chapter 13: Drawdowns and Tail Risk Management

13.1 PROTECTING AGAINST DRAWDOWNS

13.2 THE TAIL RISK PROTECTION BUSINESS

13.3 RAISING CASH AND SWITCHING TO SAFE HAVEN ASSETS

13.4 IMPLEMENTING DRAWDOWN PROTECTION STRATEGIES

13.5 TAIL RISK PROTECTION FROM OUTRIGHT FX POSITIONS

ENDNOTES

Chapter 14: Liquidity and Maturity Transformation

14.1 MONEY MARKET SPREADS

14.2 LIQUIDITY

14.3 REPO FINANCING AS THE SAFEST FORM OF INTERVAL CONFIDENCE

14.4 TOWARDS NEW MODELS OF NETWORK OR SYSTEMIC RISK

14.5 THE SHADOW BANKING SYSTEM AND LIQUIDITY RISK

14.6 MATURITY TRANSFORMATION IS SPANNING AN INTERVAL

ENDNOTES

Chapter 15: Emotional Finance and Interval Confidence

15.1 CONSTRUCTIVE AMBIGUITY

15.2 DOUBLE BINDS AND EMOTIONAL FINANCE

15.3 PATIENCE AND INVESTMENT DECISION MAKING

ENDNOTES

Chapter 16: Adjusting to More Correlated Financial Markets

16.1 SOME FINAL MUSINGS ON MARKETS AND MAYHEM

ENDNOTES

Appendix

Index

For other titles in the Wiley Finance series please see www.wiley.com/finance

© 2013 Clive Corcoran

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Library of Congress Cataloging-in-Publication Data

Corcoran, Clive M. Systemic liquidity risk and bipolar markets : wealth management in todays macro risk on/risk off financial environment / Clive Corcoran. pages cm Includes index. ISBN 978-1-118-40933-6 (hbk.) – ISBN 978-1-118-41075-2 (ebk.) – ISBN 978-1-118-41076-9 (ebk.) – ISBN 978-1-118-41080-6 (ebk.) 1. Finance, Personal. 2. Investments. 3. Portfolio management. I. Title. HG179.C68197 2013 332.024–dc23 2012039741

A catalogue record for this book is available from the British Library.

ISBN 978-1-118-40933-6 (hbk) ISBN 978-1-118-41075-2 (ebk)

ISBN 978-1-118-41076-9 (ebk) ISBN 978-1-118-41080-6 (ebk)

Foreword

In today’s tightly coupled financial system asset class returns are so highly correlated, that investors and asset managers are, to a much larger degree than previously, and very often much more than they realize, essentially undiversified and subject to the risk of abrupt and severe wealth destruction. The ultimate risk, which far exceeds the widely touted notion of tail risk, is the systemic risk which arises when liquidity in capital markets evaporates as it did in 2008 and episodically has done since – most notably in May 2010, in an incident known as the Flash Crash, and in the fall of 2011 when correlations were at historically elevated levels.

Conventional asset allocation tools and techniques have failed to keep apace with the changing financial landscape which has emerged since the 2008 global financial crisis. In addition to a decline in the quality of market liquidity, in part epitomized by the prevalence of algorithmic churn, a new paradigm of risk on/risk off asset allocation has emerged. Risk on/Risk off, sometimes abbreviated to RoRo, is a style of trading and macro allocation strategy, adopted by a broad cross section of participants in the financial markets, where positions are taken in several closely aligned asset classes depending on the prevailing sentiment or appetite for risk.

The following table shows, in summary form, a delineation between a set of asset classes which can be categorized as risk on and those which may be designated as risk off. Not all asset classes can be fitted into this twofold division and a more detailed examination of the nuances between different constituents of each of the main RoRo camps will be explored in what follows.

When markets are optimistic about such matters as economic growth, the resolution of difficult financial issues such as those facing the Eurozone, then there will be a greater propensity to acquire riskier assets. Since several classes of assets are deemed to be more suited to a portfolio when there is a greater appetite to take on risk there will be a coordinated movement of buying interest in that group of assets indicated in the left hand side of the table. Alternatively, when tactical asset allocators are more risk averse there will be a notable switch in the market into avoidance of the risk on assets and a retreat into the risk off assets as reflected on the right side of the table. For aggressive traders there will even be a tendency to short the risk on assets when risk appetite is subdued and short the risk off assets when the animal spirits are running high.

The much greater extent to which these broad movements of the different asset classes shown in the table have produced increased correlations across multiple asset classes is one of the central themes of Systemic Liquidity Risk and Bipolar Markets. The consequences of the day-to-day (and intraday) switching between either a risk on or risk off tactical strategy poses significant new challenges to investors who are still making allocation decisions with outmoded notions from the Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory (MPT). Moreover, since the 2008 financial crisis, markets are now more susceptible to sporadic volatility, temporary bouts of illiquidity, and heightened left tail dependencies – in more straightforward terms, the tendency, when markets are under stress, for most asset prices to plunge together as correlations move towards unity.

How can one cushion the impact of systemically threatening events when the ability to exit financial instruments becomes almost non-existent? How can one trust the integrity of financial models and orthodox macro financial theory when they have become increasingly discredited? Can central bankers be relied upon to become the counter-parties of last resort and provide a safety net under the financial system? These vital questions, and many others, need to be addressed by everyone who has a stake in modern financial markets, and they are addressed in this book.

For many investors still traumatized by the watershed events of 2008 there has been a growing interest in tail risk protection strategies and products. But such products often provide a spurious degree of risk mitigation and can dramatically understate the extent of damage done to one’s portfolio when bouts of illiquidity arise. Increasingly one needs to go to next generation concepts and tools to manage risk and this will entail using unorthodox strategies to minimize drawdowns. In general terms, investors need to undertake more diligent research into how asset class correlations perform under stress, and recognize that markets are far more likely to seriously misbehave than conventional risk management tools suggest. Insights from such stress analysis enable one to determine how to combine assets which are more capable of absorbing shocks in a crisis, while at the same time still providing one with an attractive upside when markets are not under stress.

Apart from the practical risk management tools and tactics that are recommended in what follows there is the strong belief that anxious and perplexed investors need a more cogent narrative to explain the post GFC financial environment, and assist them to navigate through the choppy waters ahead. New macro modeling tools may, on the surface, appear counter intuitive but in order to adequately account for the bubble and bust dynamics which are endemic to human nature and, in turn, the financial system, it will be necessary, at times, to embrace the inscrutable and ambiguous.

Proper functioning markets require fractiousness or divided opinion, and this needs to be lubricated by communications from central bankers, economic forecasters, corporate executives and so on; these then become open to adversarial interpretations. As long as such messages and market conditions remain ambiguous, providing asymmetric information to different market players, then the conditions are present to enable systemic liquidity to be preserved. Seen in this context the prevailing paradigm of bipolar risk on/risk off asset allocations is both a prerequisite to liquid markets, and also paradoxically, when one side of the polarity becomes too extreme, a major source of systemic instability. Should such polarities become critically unbalanced, and should the signals received by market players become symmetrically disadvantageous as they were in the fall of 2008, then an even more substantial systemic liquidity crisis than that seen in those troubled times is a dangerous possibility.

The principal objective in what lies ahead is to provide both a better understanding of the new characteristics and risks that are in evidence in today’s financial markets, and to offer practical steps to avoid the kind of value destruction experienced when markets crash.

ACKNOWLEDGEMENTS

I am indebted to the following people who have provided invaluable assistance in the preparation of this book: John Lounsbury, Steve Keen, Marcos Lopez de Prado, Michael Hewson, Craig Ellis, and David Tuckett. In addition for the support given by my publisher, I would like to thank Werner Coetzee, Jennie Kitchin, Tessa Allen, and, in particular, Caroline Quinnell who conscientiously edited the final draft of the manuscript. Needless to say any remaining errors remain my sole responsibility.

1

Introduction

The events of 2007/8 pulled back the magician’s curtains and revealed a rather shocking truth about the global financial system – markets can seize up and become completely illiquid. Although previous generations may have experienced similar episodes of systemic illiquidity, in the fall of 2008 the magnitude of the near meltdown came as a traumatic shock to most working in the financial world as well as those beyond. Even for assets such as short-term commercial paper and money market instruments, the liquidity which had been taken for granted completely evaporated. During Q4, 2008 the only asset class for which there was real liquidity was short-term government securities of very highly rated sovereigns. Banks did not want to deal with each other and most asset managers refused to purchase assets, where the risk of not knowing when they might be able to sell them again reflected a profound crisis in confidence regarding the efficacy of markets and the liquidity of market instruments.

At the limit there is ultimately a fundamental paradox regarding liquidity which is that when it is most required it is likely to be non-existent. John Maynard Keynes had a keen eye for noting paradoxes at the root of economic behavior, and made the following observation regarding what today would be called systemic liquidity. [1]

Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole.

To slightly paraphrase another of Keynes’s classic observations about markets, one could sum up the worst case scenario for the demand for liquidity in the following aphorism “When average opinion comes to believe that average opinion will decide to turn assets into cash, then liquidity may be confidently expected to go to zero.”

One of the central tasks of this book will be to explain [2] in as comprehensive and precise a fashion as possible the threat posed by critical financial episodes which can best be described as periods when there is a disappearance of systemic liquidity. As will become clearer, the notion of liquidity is one of the more elusive and poorly addressed concepts in the macro-economic and finance literature. Rather than assuming liquidity of markets as a given [3] a full blown account of systemic liquidity and the risks of its disappearance should be an indispensable component of any macro theory of financial economics. It is also imperative that there is recognition that we need to move beyond a view of the kind of liquidity crisis that may face an individual firm and realize that the much greater systemic threat is the kind of crisis – as seen in the second half of 2008 – where many if not most financial firms were, at the same time, confronting a liquidity crisis. One useful starting out definition for the risks posed by a systemic liquidity crisis is one proposed by the IMF in some useful analysis of the events of that troubled period. [4] “Systemic liquidity risk is the risk that multiple institutions may face simultaneous difficulties in rolling over their short-term debts or in obtaining new short-term funding through widespread dislocations of money and capital markets.” We shall return to the IMF study on systemic liquidity risk and other related analysis in later chapters and in particular in regard to the vital function of the money markets which is one of enabling maturity transformation. [5] If this ongoing facility is interrupted or breaks down there is a real risk of systemic meltdown and it will be suggested that rather than being complacent that the worst has already been seen with regard to the global financial crisis, there just might be an even bigger crisis on the horizon.

Although much of the focus in the literature on the global financial crisis is on the tumultuous events which took place in the second half of 2008 and especially in the wake of the collapse and bankruptcy of Lehman Brothers on September 15, 2008, the foreshocks of the crisis were being felt in 2007 especially during August of that year. August as a month has had a habit of producing nasty financial surprises – the LTCM crisis broke in August 1998 and it was a crisis in August 1971 that saw the US abandon gold convertibility for the US dollar [6] – and during August of 2007 there were some severe shocks to the financial system, the full implications of which would not be fully absorbed by the markets until one year later.

During August 2007, as the press release seen below indicates [7] even Goldman Sachs, which rarely acknowledges its own misfortunes, had to come to the rescue of one of its in-house hedge funds as a result of abnormal market conditions within the US markets during that time frame:

NEW YORK, August 13, 2007 – The Goldman Sachs Group, Inc. (NYSE: GS) today made the following statement: Many funds employing quantitative strategies are currently under pressure as recent conditions have resulted in significant market dislocation. Across most sectors, there has been an increase in overlapping trades, a surge in volatility and an increase in correlations. These factors have combined to challenge many of the trading algorithms used in quantitative strategies. We believe the current values that the market is assigning to the assets underlying various funds represent a discount that is not supported by the fundamentals. 

The CFO of Goldman also made the comment that “Liquidity conditions were most extraordinary during early August (2007),” and then went on with the simple minded observation: “We were seeing things that were 25-standard deviation moves, several days in a row.” We shall return to this quotation again in what follows, but at this point we can just register the fact that invoking statistical assumptions based on a normal distribution to measure such disorderly behavior was to use a model that is not fit for purpose. []