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Systemic Liquidity Risk and Bipolar Markets: Wealth Management in Today's Macro Risk On/Risk Off Financial Environment

Book Description

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.

Table of Contents

  1. Cover
  2. Series
  3. Title Page
  4. Copyright
  5. Foreword
    1. ACKNOWLEDGEMENTS
  6. Chapter 1: Introduction
    1. 1.1 HOW HELPFUL IS THE NOTION OF TAIL RISK?
    2. 1.2 DICHOTOMIES AND AMBIGUITIES
    3. 1.3 TRUST AND SOLVENCY ARE ALL OR NOTHING DICHOTOMIES
    4. 1.4 THE ASYMMETRY OF PRIVATE GAIN AND PUBLIC LOSSES
    5. ENDNOTES
  7. Chapter 2: Cross-Sectional Asset Correlations
    1. 2.1 LESSONS FOR RISK MANAGEMENT
    2. 2.2 CORRELATIONS AND VOLATILITY
    3. 2.3 INCREASED ASSET CORRELATIONS
    4. 2.4 STRESS REGRESSION ANALYSIS
    5. 2.5 HEAT MAPS ILLUSTRATE THE BINARY NATURE OF RISK ON/RISK OFF
    6. ENDNOTES
  8. Chapter 3: The Changing Character of Financial Markets
    1. 3.1 MARKET RETURNS DO EXHIBIT MEMORY
    2. 3.2 HURST COEFFICIENT
    3. 3.3 HURST VALUES REACHED EXTREMES DURING 2008
    4. ENDNOTES
  9. Chapter 4: The Flash Crash
    1. 4.1 MARKET MICROSTRUCTURE
    2. 4.2 PREDATOR PREY DYNAMICS
    3. 4.3 COMPUTER SIMULATIONS OF MARKET BEHAVIOR
    4. ENDNOTES
  10. Chapter 5: Detecting Mini Bubbles with the VPIN Metric
    1. 5.1 ADVERSE SELECTION AS THE BASIS FOR THE VPIN METHOD
    2. 5.2 THE ROLE OF THE JAPANESE YEN IN THE FLASH CRASH
    3. ENDNOTES
  11. Chapter 6: Foreign Exchange and the Carry Trade
    1. 6.1 PRIMER ON THE FOREX MARKET
    2. 6.2 THE FX CARRY TRADE
    3. 6.3 DOES THE CARRY TRADE POSE A RISK TO THE FINANCIAL SYSTEM?
    4. ENDNOTES
  12. Chapter 7: The Enigmatic Performance of the Japanese Yen
    1. 7.1 THE NIKKEI 225 AND THE YIELD ON THE US TREASURY TEN-YEAR NOTE
    2. ENDNOTES
  13. Chapter 8: The Aussie/Yen Connection
    1. 8.1 THE ROLE OF AUSSIE/YEN IN INTER-MARKET STRATEGIES
    2. ENDNOTES
  14. Chapter 9: Precursors to Illiquidity
    1. 9.1 USING HEAT MAPS FOR FX AND OTHER ASSET CORRELATIONS
    2. ENDNOTES
  15. Chapter 10: Mainstream Financial Economics Groping Towards a New Paradigm
    1. 10.1 DISAPPEARANCE OF INCOME
    2. 10.2 VENDOR FINANCING
    3. 10.3 GLOBAL IMBALANCES AND THE MARTIN WOLF THESIS
    4. 10.4 PROJECT EVALUATION AND THE COST OF CAPITAL
    5. 10.5 TOWARDS A NEW PARADIGM IN ECONOMIC THINKING
    6. 10.6 RATIONAL AND EFFICIENT MARKETS
    7. ENDNOTES
  16. Chapter 11: Could a Eurozone Breakup Trigger Another Systemic Crisis?
    1. 11.1 THE EUROPEAN STABILITY MECHANISM (ESM)
    2. 11.2 IMPACT OF MONETARY UNION
    3. 11.3 THE DEBT DEFLATION TRAP IN THE EUROZONE
    4. 11.4 EUROBONDS
    5. 11.5 THE VISCERAL DIMENSION TO THE EUROZONE’S PROBLEMS
    6. ENDNOTES
  17. Chapter 12: China, Commodities, and the Global Growth Narrative
    1. 12.1 CHINESE CONSUMPTION OF BASE METALS
    2. 12.2 THE INTERNATIONALIZATION OF THE RENMINBI
    3. ENDNOTES
  18. Chapter 13: Drawdowns and Tail Risk Management
    1. 13.1 PROTECTING AGAINST DRAWDOWNS
    2. 13.2 THE TAIL RISK PROTECTION BUSINESS
    3. 13.3 RAISING CASH AND SWITCHING TO SAFE HAVEN ASSETS
    4. 13.4 IMPLEMENTING DRAWDOWN PROTECTION STRATEGIES
    5. 13.5 TAIL RISK PROTECTION FROM OUTRIGHT FX POSITIONS
    6. ENDNOTES
  19. Chapter 14: Liquidity and Maturity Transformation
    1. 14.1 MONEY MARKET SPREADS
    2. 14.2 LIQUIDITY
    3. 14.3 REPO FINANCING AS THE SAFEST FORM OF INTERVAL CONFIDENCE
    4. 14.4 TOWARDS NEW MODELS OF NETWORK OR SYSTEMIC RISK
    5. 14.5 THE SHADOW BANKING SYSTEM AND LIQUIDITY RISK
    6. 14.6 MATURITY TRANSFORMATION IS SPANNING AN INTERVAL
    7. ENDNOTES
  20. Chapter 15: Emotional Finance and Interval Confidence
    1. 15.1 CONSTRUCTIVE AMBIGUITY
    2. 15.2 DOUBLE BINDS AND EMOTIONAL FINANCE
    3. 15.3 PATIENCE AND INVESTMENT DECISION MAKING
    4. ENDNOTES
  21. Chapter 16: Adjusting to More Correlated Financial Markets
    1. 16.1 SOME FINAL MUSINGS ON MARKETS AND MAYHEM
    2. ENDNOTES
  22. Appendix
  23. Index