What is endogenous market risk?
We define endogenous market risk as the difference between downside and upside risk to the mark-to-market performance of a position that arises from investor positioning and is unrelated to the fundamental value of the underlying assets. Thus this risk is due mainly to market dynamics, rather than exogenous shocks, such as changes in “fundamentals”. It can also be called “setback risk” because it indicates that the market may need to revert to a state where positions are “cleaner”, meaning less crowded and reliant on leverage. This risk arises even if the value proposition of the trade remains perfectly valid. In fact, it is often the trades that offer the clearest and most plausible long-term expected value that incur the greatest endogenous market risk. This is consistent with negative skews in the returns of many risk premium strategies. For example, FX carry trade returns have historically displayed larger negative than positive outliers (view post here).
Endogenous market risk is the natural counterweight to many dominant positioning motives, such as implicit subsidies, fundamental trends or even simple momentum trading. For example, for momentum strategies there is empirical evidence of greater sensitivity to downside than to upside market risk across asset classes (view post here). The presence of endogenous market risk has profound consequences. The probability for future price moves is skewed against dominant positioning motives and has “fat tails”. Large adverse outliers relative to standard deviations should be expected.
Information on endogenous market risk can come from various sources, including positioning data, short-term correlation of PnL’s with hedge fund benchmarks, asymmetries of upside and downside market correlation, or simply past performance and the popularity of trades in broker research recommendation. Endogenous market risk of relative value and arbitrage trades often arises from outflows in the hedge fund industry, which in conjunction with interactions and short-term performance targets can lead to panic runs (forthcoming post). Also, some forms of endogenous market risk can be detected through theoretical models: for example compressed interest rate term premia at the zero lower bound for policy rates are naturally quite vulnerable to any risk of future rates increases (view post here).
Information efficiency on endogenous market risk creates social value by reducing the risk of dislocation and crisis. It creates investor value by reducing the occurrence of large outsized drawdowns and forced expensive position liquidations.