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.
Foreword ix 1 Introduction 1 1.1 How Helpful is the Notion of Tail Risk? 10 1.2 Dichotomies and Ambiguities 14 1.3 Trust and Solvency are All or Nothing Dichotomies 14 1.4 The Asymmetry of Private Gain and Public Losses 18 2 Cross-Sectional Asset Correlations 27 2.1 Lessons for Risk Management 35 2.2 Correlations and Volatility 36 2.3 Increased Asset Correlations 42 2.4 Stress Regression Analysis 45 2.5 Heat Maps Illustrate the Binary Nature of Risk On/Risk Off 49 3 The Changing Character of Financial Markets 61 3.1 Market Returns Do Exhibit Memory 66 3.2 Hurst Coefficient 70 3.3 Hurst Values Reached Extremes During 2008 72 4 The Flash Crash 81 4.1 Market Microstructure 86 4.2 Predator Prey Dynamics 88 4.3 Computer Simulations of Market Behavior 90 5 Detecting Mini Bubbles with the VPIN Metric 97 5.1 Adverse Selection as the Basis for the VPIN Method 98 5.2 The Role of the Japanese Yen in the Flash Crash 110 6 Foreign Exchange and the Carry Trade 119 6.1 Primer on the Forex Market 120 6.2 The FX Carry Trade 122 6.3 Does the Carry Trade Pose a Risk to the Financial System? 123 7 The Enigmatic Performance of the Japanese Yen 133 7.1 The Nikkei 225 and the Yield on the US Treasury Ten-Year Note 137 8 The Aussie/Yen Connection 149 8.1 The Role of Aussie/Yen in Inter-Market Strategies 157 9 Precursors to Illiquidity 165 9.1 Using Heat Maps for FX and Other Asset Correlations 166 10 Mainstream Financial Economics Groping Towards a New Paradigm 175 10.1 Disappearance of Income 176 10.2 Vendor Financing 183 10.3 Global Imbalances and the Martin Wolf Thesis 183 10.4 Project Evaluation and the Cost of Capital 186 10.5 Towards a New Paradigm in Economic Thinking 187 10.6 Rational and Efficient Markets 190 11 Could a Eurozone Breakup Trigger Another Systemic Crisis? 201 11.1 The European Stability Mechanism (ESM) 209 11.2 Impact of Monetary Union 211 11.3 The Debt Deflation Trap in the Eurozone 214 11.4 Eurobonds 218 11.5 The Visceral Dimension to the Eurozone's Problems 221 12 China, Commodities, and the Global Growth Narrative 227 12.1 Chinese Consumption of Base Metals 235 12.2 The Internationalization of the Renminbi 243 13 Drawdowns and Tail Risk Management 251 13.1 Protecting Against Drawdowns 260 13.2 The Tail Risk Protection Business 265 13.3 Raising Cash and Switching to Safe Haven Assets 267 13.4 Implementing Drawdown Protection Strategies 270 13.5 Tail Risk Protection from Outright FX Positions 273 14 Liquidity and Maturity Transformation 285 14.1 Money Market Spreads 291 14.2 Liquidity 294 14.3 Repo Financing as the Safest Form of Interval Confidence 295 14.4 Towards New Models of Network or Systemic Risk 298 14.5 The Shadow Banking System and Liquidity Risk 299 14.6 Maturity Transformation is Spanning an Interval 299 15 Emotional Finance and Interval Confidence 307 15.1 Constructive Ambiguity 308 15.2 Double Binds and Emotional Finance 311 15.3 Patience and Investment Decision Making 318 16 Adjusting to More Correlated Financial Markets 327 16.1 Some Final Musings on Markets and Mayhem 331 Endnotes 334 Appendix 337 Index 343
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