Market Dislocations Research Articles

Losing One’s Place: Narratives of Neighbourhood Change, Market Injustice and Symbolic Displacement

This article examines the narratives offered by those displaced through the gentrification of neighbourhoods in Melbourne and Sydney. Extensive qualitative interview data generated from encounters with self-identified displacees in these cities is used here to examine their responses to changes in and after they moved from their originating neighbourhoods and the impacts these changes had on them. This data reveals that despite displacement commonly being defined in terms of physical movement, in many cases, participants became dislocated and isolated by the physical and social changes that took place while still residing in neighbourhoods as they changed. The article traces these twin modes of displacement – both as a series of impacts generated by direct market dislocation but also as feelings of loss connected with a home that might be imminently lost and the cherished place around it. These narratives reveal how private renters respond to a symbolic violence that they locate in a changing built environment and a shifting social physiognomy that impinges and threatens the viability of their tenure of these places. The article locates these resentments and displacements within a sociopolitical context that celebrates ownership and investment in the very homes and places that are now lost to them.

Asset Management and Systemic Risk

As regulators around the world progress towards prudential reforms of the global financial system to address the issue of systemic risk, the sweeping scope of the task touches areas and actors of the financial markets that have typically not been seen as systemically important before. The idea that the asset management industry can contribute to systemic risk is new, and warrants detailed examination in order to shape adequate policies. In this paper, after reviewing the definition of systemic risk and how systemically important banks and insurance are designated, we review the activities of the asset management industry and the ways they can contribute to the transmission of systemic risk. We then look in detail at the March 2015 proposal by FSB-IOSCO for an assessment methodology for the identification of non-bank non-insurance systemically important financial institutions. We compare and discuss with empirical data how the methodology fairs against what the literature and the aftermath of the 2007-2008 crisis reveals about the role of the asset management industry in contributing to systemic risk. We find that the current proposal in part fails to adequately identify natural candidates for the systemically important designation and perhaps confuses large institutions with systemically strategic institutions giving wealth loss too much importance over the potential for real economic disruption and market dislocation. Finally, we call for a more robust an risk-sensitive approach to identifying systemically important financial institutions.

Extreme Correlations and Optimizing for Stress

Asset correlations often change significantly during periods of financial market dislocation. This article describes a rigorous way of deriving a covariance matrix for use in stressed market environments. This lets investors apply standard mean–variance techniques to analyze investment strategy under extreme conditions. Applications include risk management and constructing optimally defensive portfolios for stressed markets. The method is based on recent advances in multivariate extreme-value theory. <b>TOPICS:</b>Portfolio theory, volatility measures, in portfolio management

Chasing market dislocation: The LIBOR shifted model

We introduce a flexible multivariate extension to the LIBOR market model that is analytically tractable. The flexibility of the model is a solution to the interest rate market dislocation that happened on the credit crunch aftermath in August 2007. The extension is based on a parameter uncertainty modeled through a random variable whose value is drawn at an infinitesimal time after zero. The proposed shift captures the skew commonly seen in the cap market, whereas the uncertain volatility component of the model allows us to obtain more general implied volatility structures. We show how this model can be calibrated to cap prices. We also propose an analytical approximated formula to price swaptions from the cap calibrated model. Finally, we build a bridge between the caps and swaptions markets by calibrating the correlation structure to swaption prices, and analysing some implications of the calibrated model parameters.

Financial Market Dislocations

Dislocations occur when financial markets, operating under stressful conditions, experience large, widespread asset mispricings. This study documents systematic dislocations in world capital markets and the importance of their fluctuations for expected asset returns. Our novel, model-free measure of these dislocations is a monthly average of hundreds of individual abnormal absolute violations of three textbook arbitrage parities in stock, foreign exchange, and money markets. We find that investors demand statistically and economically significant risk premiums to hold financial assets performing poorly during market dislocations, that is, when both frictions to the trading activity of speculators and arbitrageurs and their marginal utility of wealth are likely to be high.

Resource Allocation within Firms and Financial Market Dislocation: Evidence from Diversified Conglomerates

We argue and demonstrate that resource allocation within firms' internal capital markets provides an important force countervailing financial market dislocation. We estimate a structural model of internal capital markets to separately identify and quantify the forces driving the reallocation decision and illustrate how these forces interact with external capital market stress. The weaker (stronger) division obtains too much (little) capital, as though it is 12% (9%) more (less) productive than it really is. Out-of-sample simulated data are consistent with the actual data showing that internal capital markets offset financial market stress during the recent financial crisis by 16%–30%.

European Equity Investing Through the Financial Crisis: Can Risk Parity, Momentum or Trend Following Help to Reduce Tail Risk?

A growing body of literature suggests that over widely varying historical eras and across a wide range of asset classes momentum investing, often accompanied by a trend following overlay, provides superior risk-adjusted returns. We examine the effectiveness of applying these methodologies to pan-European equity asset allocation through periods of potentially substantial market dislocation, in particular, with the advent of the single currency and the equity market crashes of the early 2000’s and 2008. With the introduction of the Euro there has been much discussion of the benefits of diversification via country based portfolios versus industry sector portfolios. Early studies simply looked at changing return correlations over time. The simple conclusion that increasing country correlations over time drives superior risk-adjusted portfolios towards diversification across sectors has been increasingly challenged. Our approach is different in that we apply momentum and trend following investing strategies and assess whether it is sectoral or country indices which dominate our portfolios through periods of structural changes and extreme volatility. Diversification via sectors is clearly the best strategy in times of equity market stress. In addition, the application of trend following offers a substantial improvement in risk-adjusted performance compared to traditional buy-and-hold portfolios. The terms momentum and trend following have often been used interchangeably although the former is a relative concept and the latter absolute. By combining the two we find that one can achieve the higher return levels associated with momentum portfolios but with much reduced volatility, tail risk and drawdowns due to trend following. We observe that a flexible asset allocation strategy that allocates capital to the best performing instruments irrespective of asset class enhances this further. Such methodologies offer superior risk adjusted returns, especially through periods of raised market volatility.

Nowcasting and forecasting global financial sector stress and credit market dislocation

We introduce a new international model for the systematic distress risk of financial institutions from the US, the European Union, and the Asia-Pacific region. Our proposed dynamic factor model can be represented as a nonlinear, non-Gaussian state space model with parameters that we estimate using Monte Carlo maximum likelihood methods. We construct measures of global financial sector risk and of credit market dislocation, where credit market dislocation is defined as a significant and persistent decoupling of the credit risk cycle from macro-financial fundamentals in one or more regions. We show that, in the past, such decoupling has preceded episodes of systemic financial distress. Our new measure provides a risk-based indicator of credit conditions, and as such, complements earlier quantity-based indicators from the literature. In an extensive comparison with such quantity-based systemic risk indicators, we find that the behaviour of the new indicator is competitive with that of the best quantity-based indicators.

Aluminum Market Dislocation: Evidence, Incentives and Reform

Are major aluminum players colluding to drive up the price of this metal, crucial to the production of everything from beer cans to airplanes? A first look at the empirical evidence, combined with an analysis of the structure and incentives in this market, suggests that this possibility is worth the authorities’ attention. At the least, reform in this market seems to be in order.

Flight to Quality and Asset Allocation in a Financial Crisis

With respect to the recent financial crisis, the authors argue that the appropriate adjustments to portfolio allocations in response to the market dislocation are determined by equilibrium considerations (supply must equal demand) and depend on individual investors’ characteristics relative to societal averages. Using a simple model that captures the magnitude of the recent crisis, the authors show that the optimal tactical adjustments for most portfolios require a turnover of less than 10%.

European Equity Investing Through the Financial Crisis: Can Risk Parity, Momentum or Trend Following Help to Reduce Tail Risk?

A growing body of literature suggests that over widely varying historical eras and across a wide range of asset classes momentum investing, often accompanied by a trend following overlay, provides superior risk-adjusted returns. We examine the effectiveness of applying these methodologies to pan-European equity asset allocation through periods of potentially substantial market dislocation, in particular, with the advent of the single currency and the equity market crashes of the early 2000’s and 2008.With the introduction of the Euro there has been much discussion of the benefits of diversification via country based portfolios versus industry sector portfolios. Early studies simply looked at changing return correlations over time. The simple conclusion that increasing country correlations over time drives superior risk-adjusted portfolios towards diversification across sectors has been increasingly challenged. Our approach is different in that we apply momentum and trend following investing strategies and assess whether it is sectoral or country indices which dominate our portfolios through periods of structural changes and extreme volatility. Diversification via sectors is clearly the best strategy in times of equity market stress. In addition, the application of trend following offers a substantial improvement in risk-adjusted performance compared to traditional buy-and-hold portfolios. The terms momentum and trend following have often been used interchangeably although the former is a relative concept and the latter absolute. By combining the two we find that one can achieve the higher return levels associated with momentum portfolios but with much reduced volatility, tail risk and drawdowns due to trend following. We observe that a flexible asset allocation strategy that allocates capital to the best performing instruments irrespective of asset class enhances this further. Such methodologies offer superior risk adjusted returns, especially through periods of raised market volatility.

Bailouts and Longer Term Refinancing Operations: When Temporary Cures Generate Longer Term Economic Concerns

It is increasingly becoming apparent to domestic and international investors that the European Central Bank’s bond buying programme which commenced in May 2010, “a way of correcting market dislocations that were hampering the central bank’s conduct of monetary policy”, and its provision of much cheaper Longer Term Refinancing Operations (LTROs), constitute more of temporary, expected continuous measures aimed at addressing the Euro zone’s sovereign debt problems (through fostering demand for sovereign debt and damping increases in yields). This paper is aimed at evaluating means whereby a redress of the Euro zone’s sovereign debt problems could be effectively achieved. In addition to present regulatory efforts and regulatory measures, it also considers other measures - one of which aims to combine “quantitative easing” schemes with other policies which would effectively address the need to reduce the debt burden of countries such as Greece, Portugal, Spain, Ireland and Italy, whilst incorporating corrective measures which lead to a growth in economic activities as well as increased competitiveness. The emphasis on tough fiscal measures - rather than the need for more stringent regulatory financial reforms is also considered to have played a contributory role – not only in the difficulty encountered by heavily indebted countries in reducing their levels of sovereign debts, but also creating further debts.

Resource Allocation within Firms and Financial Market Dislocation: Evidence from Diversified Conglomerates

When external capital markets are stressed they may not reallocate resources between firms. We show that resource allocation within firms' internal capital markets provides an important force countervailing financial market dislocation. Using data on U.S. conglomerates we empirically verify that firms shift resources between industries in response to shocks to the financial sector. We estimate a structural model of internal capital markets to separately identify and quantify the forces driving the reallocation decision and illustrate how these forces interact with external capital market stress. The frictions in internal capital markets drive a large wedge between productivity and investment: the weaker (stronger) division obtains too much (little) capital, as though it is 12 (9) percent more (less) productive than it really is. The cost of accessing external capital funds quadruples during extreme financial market dislocations, making resource allocation within firms significantly cheaper. The estimated model allows us to simulate the propagation of the 2007/2008 financial market dislocation. The counterfactual out of sample simulated data is remarkably consistent with the actual data and shows that improved resource allocation in internal capital markets offset financial market stress during the recent financial crisis by 16% to 30% relative to firms with no internal capital markets.

Dynamic Investor Base, Momentum, and the Fog of Expectations

This paper illustrates that when CAPM is expanded to incorporate an investor base with heterogeneous risk aversions over a multi-period timeframe, a more realistic model is revealed which explains many return attributes previously considered to be anomalies. Investor concentrations in the market portfolio shift as investors’ wealth grows at differing rates and assets are reallocated to optimize individual capital allocations. During sustained up-trends in the market, less risk adverse investors will crowd out those with greater aversion, and vice versa during down-trends. Serial momentum and changing market-clearing risk coefficients result from a dynamic investor base in the presence of constant relative risk aversion at an individual level. The implications of this are significant and expansive. When CAPM is considered in the context of a dynamic investor base, we can harmonize the theoretical foundations of CAPM with empirical deviations such as: price bubbles, out performance of low-beta stocks and the momentum phenomenon. Additionally, this research suggests markets have serial correlation and build up momentum-driven price distortions, in contradiction to the Efficient-Market Hypothesis. Finally, and perhaps most important, is the real world applicability of this model to quantify the significance of momentum as it relates to current and past market dislocations.

Financial Market Dislocations

Dislocations occur when financial markets, operating under stressful conditions, experience large, widespread asset mispricings. This study documents systematic dislocations in world capital markets and the importance of their fluctuations for expected asset returns. Our novel, model-free measure of these dislocations is a monthly average of six hundred abnormal absolute violations of three textbook arbitrage parities in stock, foreign exchange, and money markets. We find that investors demand economically and statistically significant risk premiums to hold financial assets performing poorly during market dislocations.

Policy Portfolios and Rebalancing Behavior

An institutional fund typically has a multi-asset allocation—the policy portfolio—that is maintained over time. When allocations shift, the fund rebalances back to the policy portfolio. The discipline of the policy portfolio has many benefits: simplicity, convenient benchmarking, and a minimum of organizational frictions. Its very routine nature can lead, however, to an overemphasis on relative returns and an insensitivity to fundamental changes in fund status and market structure. In 2003, the late Peter Bernstein questioned whether rigid adherence to the policy portfolio made sense, given frequent market dislocations and high levels of volatility. In this article, Liebowitz and Bova attempt to shed further light on the Bernstein question by analyzing the risk tolerance and return assumptions of a basic two-asset (equity and cash) fund. One key finding is that policy portfolio rebalancing implicitly assumes that the risk tolerance and return premiums remain fixed over time. But few funds have the sponsorship, liquidity, or organizational conviction to keep such a constant risk tolerance in the face of severely adverse markets. One argument for the policy portfolio rebalancing is that assets become “cheaper” after a decline, but this is inconsistent with a constant return premium. Moreover, “cheaper” assets should actually call for rebalancing beyond the original policy portfolio to a more aggressive allocation. One idea for a more pro-active, market-sensitive process is to develop pre-planned contingency actions for various market scenarios. <b>TOPICS:</b>Portfolio theory, equity portfolio management

Financial Market Dislocations

Financial Market Dislocations

A Common Definition of European Money Market Funds: More Clarity or More Confusion?

Money market funds (MMFs) that started as a U.S. phenomenon in 1971, in nearly forty years have grown into a $5.8 trillion global industry. In the early 1980s the European investment management community adopted MMFs with certain variations to fit the local legislations and practices. The market dislocation of 2007–2009 exacerbated by the liquidity crisis that followed the bankruptcy of the Lehman Brothers have led financial regulators in all major jurisdictions to review the existing policies. The European Union now is facing even greater challenges due to the fragmented nature of the local markets and the lack of regulatory consistency. The de Larosiere report published in February 2009 pointed out that an efficient Single Market should have a harmonized set of core rules. This article focuses on the recent initiative undertaken by the Committee of European Securities Regulators (CESRs) to follow up on the de Larosiere’s report recommendations in introducing a common definition for European MMFs. Section I of the article is an introduction into the past and the present of the MMF industry in the U.S. and Europe. Section II reviews existing definitions of MMFs. Section III analyses regulated elements of investment management and operational practices applicable to MMFs including risk-limiting provisions of the recent MMF Reform implemented by the U.S. Securities and Exchange Commission (SEC). While I support the CESRs’ efforts in introducing a common EU definition of MMFs, the diversities of the European financial markets call for a better delineation of seemingly homogenous investment schemes. The article concludes by re-emphasizing the importance of a consistent regulatory guidance for the creation of an efficient and transparent Single Market. The paper is an initial step in a much larger research project on comparative regulation of the global money markets and cash management. Even further, I study the impact of financial markets on law and regulation and vise versa regulatory response to market developments in the narrow focus of money market fund industry. The historical record supports the thesis that the law matters to the development of the transparent and efficient global financial markets. My approach is historical in orientation and starts with an attempt to define MMFs as a subject of regulation.

Higher-Order Volatility: Time Series

This paper presents time-series of higher-order volatilities for the SP accordingly we term them base, and volatility. We define instantaneous skewness and kurtosis as simple ratios of the volatilities, and show that when these metrics are held constant, the model is relative sticky-delta. For the S&P 500 in 2008, skew and smile volatility are highly correlated with base volatility. Instantaneous skewness and kurtosis are remarkably stable, including over the market dislocation of the last four months of the year. Daily changes in all three volatilities are correlated with daily returns. For EURUSD in 2006, base and smile volatility are closely correlated, but in contrast to the equity case, skew volatility is independent and changes sign. This change in sign appears to provide advance warning of the two major market moves of the year. However, daily changes in the volatilities are uncorrelated with daily returns.

Dislocations in FX Swap and Money Markets in Hong Kong and Policy Actions during the Financial Crisis of 2008

When US dollar interbank markets malfunctioned during the global financial crisis of 2008, many non-US financial institutions relied heavily on FX swap markets for US dollar funds. This one-sided market induced a risk premium of the FX swap-implied US dollar rate across a range of funding currencies, i.e. a deviation from the covered interest parity (CIP) condition. The turbulence in the global interbank markets therefore spilled over to the FX swap markets, including that in Hong Kong. This paper analyses the effectiveness of the policy actions taken by the Hong Kong Monetary Authority and the government in responding to the dislocations and stress in the local interbank and FX swap markets. Our results show that the policy actions effectively ameliorated the FX swap market dislocations after the failure of Lehman Brothers, i.e. reducing the CIP deviations.