Sunday, November 5, 2017

The "Paradox of Prudence" - It is real and needs your attention

Our thinking of systematic risk has to be in two dimensions; one, the time series impact and two, the cross-sectional impact. These financial insights are coming from Markus Brunnermeier in his piece "Paradox of Prudence". The time series component focuses with the build-up of risks, and the cross-sectional component focuses with the transfer of risks. This leads to two paradoxes. 

  • The "volatility paradox" - Low volatility today leads to more risk-taking and higher leverage which will lead to more volatility tomorrow. Low volatility causes more risk-taking which makes the economy more sensitive to any shock. The seeds of future risk tomorrow are found in the low volatility of today. 
  • The "Paradox of Prudence" - Each firm tries to reduce risk exposure and be micro-prudent, but this leads to more systematic risk and is macro-imprudent. While some behavior can be market risk tampering, risk management can also be risk amplifying for the economy as a whole. Attempting to control your risk will spill-over to other firm. 
We usually focus on the times series, but the actual risk will be in the networks between firms and the behavior of firms to specific risk shock. A shock to any firm will propagate through the economy through firm linkages. 

The potential advantage of global macro and managed futures comes from their ability to take advantage of cross asset class spill-over of risks. An equity shock may spill-over to bonds which can impact currencies. The global macro manager can trade these differences.

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