Monday, January 18, 2016
Exogenous vs. Endogenous Risk - It is an endogenous risk year
Risk can be separated into two types - exogenous and endogenous. Exogenous risks are the ones that we most often discuss and model, but endogenous risks may be the most dangerous because they are not easy to describe or measure.
Exogenous risks are those associated with news - the fundamentals that drive markets. They can be the latest announcement from the Fed, or the new employment numbers. The risk from these announcements will be unanticipated, but the impact is often well recognized. These risks are the measurable or explained volatility in markets. These risks will be related to model structures. The behavior of traders and investors are well-defined and rational with respect to these risks. These risks help to formulate expectations because the models describing the economy are known. You could call the battle to measure and assess these risks as a game against nature.
Endogenous risks are the risks derived from the trading in markets. These risks are the unexplained volatility that does not have a link with specific factors. These risk will be non-fundamental or associated with technical factors. The reactions to support or resistance will be endogenous risks. The risk to bandwagon or momentum effects will an endogenous risk.These will be beauty pageant risks - the risk associated with trying to handicap the expectations of others. These are the risks when the model of pricing is unknown. These are the risks with trying to second guess the expectations of others. It is a game against others. These risks are inherently non-linear.
The work on the decomposition of risks was developed by Prof Modecai Kurz and popularized by Woody Brock. The framework has been around for over 20 years but has not gotten the interest it should. Much of stock decline in the last month can be associated with endogenous risks. The behavior of the markets themselves and the structure of trading has been negatively biased. There has been significant uncertainty unrelated to news. This is likely to continue and will not change based on the fundamental actions of policy-makers.