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Systemic Liquidity Risk and Bipolar Markets: Wealth Management in Today's Macro Risk On / Risk Off Financial Environment


The dramatic and well-chronicled crisis of 2007/2008 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 subject to the risk of severe wealth destruction. The ultimate hazard, which is understated and not adequately characterised by the widely touted notion of tail risk, is the systemic risk which arises when liquidity in markets completely evaporates.

Legacy modeling tools for asset allocation have failed to keep apace with the changing financial landscape since 2008. In addition to a decline in the quality of market liquidity, in part epitomised by the prevalence of algorithmic churn, a new paradigm of risk on/risk off asset allocation has emerged.  Increasingly it is necessary to go to next generation concepts and tools to manage risk and this will entail using unorthodox strategies to minimise drawdowns.  In general terms, investors need to undertake more diligent research into how asset class correlations perform under stress, and recognise that markets are far more likely to seriously misbehave than conventional risk management tools suggest. Insights from such stress analysis make it possible to determine how to combine assets which are more capable of absorbing shocks in a crisis, while at the same time still proving an attractive upside when markets are not under stress.

Systemic Liquidity Risk and Bipolar Markets delivers practical risk management tools and tactics alongside a provocative and cogent narrative to provide investors with a coherent explanation of the post global financial crisis environment. The book begins with an introduction to Systemic Liquidity Risk and goes on to discuss its relevance in today’s financial markets. Asset Correlations, The Flash Crash, the Eurozone Crisis and Tail Risk Management are just some of the topics covered in chapters relating to all of the current issues faced by investors today.

Written by a respected authority on risk reduction and market-neutral investment strategies, the key objective of the book is to provide both a better understanding of the new characteristics and risks that are in evidence in today’s markets, and to offer practical steps to avoid the kind of value destruction experienced when markets crash.

Clive Corcoran has been an independent trader, on both sides of the Atlantic, for more than 20 years. In recent years he has been engaged as a course developer and tutor, providing international executive education workshops and individual mentoring. He is also an FSA registered adviser and provides wealth management services and investment advice to private clients. As an author he has written Long/Short Market Dynamics: Trading Strategies for Today’s Markets (Wiley, 2007) and several titles for the Chartered Institute for Securities and Investment (CISI). He has been a regular analyst/contributor to CNBC Europe and other broadcast outlets, runs executive education workshops in conjunction with Euromoney, ICMA and Thomson Reuters, and has been a featured speaker at international trading and investment expos.

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