How to invest in a low Risk Aversion mode

Posted on 10. Sep, 2012 by Jean Jacques Ohana in Weekly Focus | Comments Off

Riskelia’s heat map of financial risks (figure 1) dynamically pictures a normalized fear index reflecting more than 100 quoted risk premium in financial markets: implied volatility, credit spreads, CDS and monetary liquidity spreads like the LIBOR/OIS spread. Every type of financial vulnerability has eased since June 2012, notably the euro funding risk which had been under stress since 2010. For instance, figure 2 illustrates that complacent financial markets want to ignore the euro zone risks as the CDS of Spain, Italy and their largest banks have dropped under their long term moving average. The global easing of financial markets must inspire caution as the marginal benefit of Quantitative Easing policies is decreasing over time.

This week will be critical to confirm the low risk environment as the Federal Reserve decision on QE III is largely expected by market anticipants while the German Constitutional Court ruling on the legality of the FESF (as well as ESM) scheme is needed to support Mario Draghi’s plan of unlimited euro zone bonds purchases.

Risk Aversion has two major properties which can improve allocation decisions:

  • It is asymmetric, i.e. the fear reached in financial crises is potentially much higher than the confidence achieved in stable environment. Therefore, filtering regime of positive risk aversion may help avoid major losses associated to systemic financial crises. In these rare chaotic instances, extreme losses prevail due to positive feedback effects.

     

  • It is persistent over time, which means that lasting phases of market confidence follow sustained period of stresses characterized by cross-market contagions.

Figure 3 helps design possible market scenarios associated to low Risk Aversion regimes such as the one we are presently going through. When Risk Aversion is low, the equities tail risk is reduced compared to other phases up to a horizon of 250 trading days. In parallel, the mean return is higher when Risk Aversion is lower than -0.5, which reveals that investors are not compensated by a premium to bear the risk associated to a high Risk Aversion regime (figure 4).

Last but not least, we present various financial assets behavior conditional on Risk Aversion regimes. Low Risk Aversion regime benefits the Risky Asset classes e.g. equities, commodities, carry trades whereas high Risk Aversion regime favors safe haven assets e.g. US and German bonds.

Figure 1: Risk Aversion financial heat map. The marginal benefit of liquidity injections is decreasing over time.




 

Figure 2: Risk Aversion Indicators on Italy, Spain and their largest banks




 

Figure 3: 2002-2012 – Global equities distribution of returns over a one year period conditional on a Risk Aversion below -0.5.



Figure 4: Performance of an Equities Basket conditional on Risk Aversion.


 

Figure 5: Sharpe Ratios on various assets over the period 2002-2012 conditional on Risk Aversion.

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