Monitoring Market Fragility Using the Absorption Ratio

Abstract

The objective of this report is to introduce a measure called the absorption ratio, for monitoring systemic risk in the South African environment. We follow an academic paper by Kritzman, Li, Page and Rigobon (2011) who proposed this metric. The measure is intended to signal when the market is becoming highly fragile because risk is beginning to concentrate in a narrow direction. We extend these ideas to measure the systemic risk of an individual portfolio.The absorption ratio is essentially the fraction of a set of assets’ total variance ‘absorbed’ by a fixed number of risk factors. A high absorption ratio suggests the risk in the market is beginning to concentrate, making it vulnerable to a narrow negative shock. Our empirical analysis assesses an equity market environment and a typical local portfolio. The evidence in both cases shows there was an increase in the absorption ratio prior to significant losses in the market. Interestingly, the results also show that, subsequent to the 2008 crash, the absorption ratio remained at relatively high levels, indicating that the market remained fragile and vulnerable to any further narrow shocks - but that perhaps bail-outs averted any further shocks.Our results using both data sets thus confirm the usefulness of the absorption ratio as a signalling metric of rising systemic risk in the South African environment.