Managing Global Volatility
13 Pages Posted: 5 May 2003
We define global volatility as the weighted average volatility of four major asset classes (Equities, Fixed Income, Foreign Exchange and Commodities), with weights based on Market Capitalization. Equity and Fixed Income account for 70% of the weight and we primarily focus on them.
The developments in financial engineering and risk management in the last two decades has led to a spreading of risks between different institutions. Banks today are remarkably healthy with bad loans accounting for barely 10% of Bank's Equity. This is primarily because banks are net buyers of protection. Commercial banks have sold a significant slice of their risks to insurance and re-insurance companies.
Now, the credit derivative market is very illiquid, primarily because there is no consensus on how to price credit derivatives. Different banks use different models and these values differ significantly. This forces the insurers/re-insurers to either use the less liquid bond market or the more liquid equity market to hedge their risks. Specifically, they go short to hedge themselves. Further, as markets fall, insurers respond by selling more, which in turn leads to points of extreme volatility and dislocation. Also the insurer makes his money on shorting equities and uses a part of this to pay back the bank the defaulted loan. The essential point to note is that the insurer can be the market maker.
The bigger problem is however that the movement of risks off bank balance sheets and into the asset books of insurance companies led to a greater convergence in the way risks are valued, traded, managed and hedged. Instead of there being at least two views of risk - one privately held by the loan officers and one publicly held by the equity markets - there is now only one. This convergence results in a concentration of risks across time and markets.
To combat this increase in volatility we suggest first, improving liquidity in credit derivatives by agreeing on a fair pricing method. Second, regulators have tried to impose high and 'common' standards for both banks and insurers, but to reduce risk we need diversity in its treatment. And third, to limit participation in equity markets by pension funds and insurance/re-insurance companies.
Keywords: shifting of risks, spreading of risks, global volatility
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