Modern shadow banking provides large-scale risk transformation services that are highly pro-cyclical (view post here). This is a systemic concern mainly for one reason: most shadow banking activities lack formal transparent backstops, i.e. external risk absorption mechanisms that prevent large negative shocks from escalating.
How Fed asset purchases reduce yield term premia
An updated Federal Reserve paper suggests that there has long been a link between the net supply of government securities and term premia on Treasury yields. A 1%-point reduction in the ratio of Treasuries or MBS (10-year equivalent) to GDP supposedly reduced the 10-year term premium by 10 basis points. A one-year shortening of the average effective duration would lower the ten-year Treasury yield by about 7 basis points. Based on these estimates, the 2008-2011 large scale asset purchase and maturity extension programs of the Federal Reserve could have reduced the 10-year term premium by a total of 150 basis points.
High-speed trading: lessons from quantum physics
Modern physics teaches that objects behave differently as they reach the speed of light. This has become relevant for financial market execution. While prices pretend to be global, in reality they depend on location. Liquidity at any given price is uncertain. And physical location becomes critical for the success of certain trading styles. Moreover, quantum physics suggest that ‘freak events’ that destabilize the markets are likely to occur.
Developed market bond yields and systemic EM risk
A new BIS paper argues that the expansion of EM local-currency bond markets and foreign-currency EM corporate issuance have strengthened the link between local EM financial conditions and global bond yields. The consequences would be (i) increased dependence of emerging financial systems on developed countries’ non-conventional monetary policies, (ii) decreased effectiveness of local monetary policies, and (iii) new systemic risks.
The rise and risks of central counterparty clearing
A brief speech by ECB governing council member Benoît Cœuré summarizes problematic side effects of increased central counterparty clearing in derivatives markets. Systemic threats may arise from unprecedented risk concentrations in a few global central counterparties and participating banks, as well as from the mutualisation of losses and liquidity shortfalls across systemically important institutions.
Herding in financial markets
Herding is a deliberate decision to imitate the actions of others. In financial markets with private information herding can be efficient for an individual asset manager, but increases the risks that the market as a whole is inefficient and fragile, particularly in the case of “information cascades”. A paper of Michael McAleer and Kim Randalj provides empirical evidence of herding in a range of futures markets.
Volatility insurance and exchange rate predictability
The cost of insuring against currency volatility can be measured as the difference between (options-based) implied volatility and (swaps-based) forward expected realized volatility. A case can be made that this insurance premium determines how much exposure risk-averse institutions are willing to accept. A new paper and blog post by Della Corte, Ramadorai, and Sarno claim that variations in volatility insurance costs can be the basis for a profitable currency trading strategy.
Estimating China’s augmented fiscal debt and deficit
The IMF, like other institutions, estimates that China’s fiscal position is much weaker than suggested by headline statistics. A new paper sees the augmented fiscal debt at around to 45% of GDP and the augmented fiscal deficit at close to 10% of GDP. Financial stability risks arise from dependence on a favorable ratio of growth to real interest rates, the reliance of local budgets on real estate sales, and the refinancing of local government financing vehicles’ debt.
The concept of “real financial exchange rates”
A Bundesbank paper proposes a new type of real exchange rate index. Rather than measuring the competitiveness of goods markets, this “real financial exchange rate” would measure the competitiveness of asset markets. There is some evidence that this indicator helps detecting overvaluation.
Trend following in U.S. equities
Trend following is a systematic investment style that takes directional positions in accordance with the difference between the current price and a moving average. For longer moving averages most trend following strategies would have outperformed simple buy-and-hold and value-based strategies in U.S. equities for many decades. Moreover, the simplest rules have been the best: there has been no benefit in high-frequency trading, stop losses, and conventional complications.
