Tuesday, March 24, 2020

The stress process - There are different stages of financial stress

In an effort to make sense of the current market shock, a crisis can be decomposed into a number of different market stresses. A shock will first cause a market stress and switch from risk-on to risk-off sentiment. If the shock is a large and common across more markets, there will be a movement to a correlation of one. As markets start to a correlation to one, there is a liquidity stress as markets become one-sided and bid-ask spreads widen. As the financial impact deepens, there is limits to arbitrage stress. Margins increase, collateral loses value and normal market linkages cannot be maintained. Financing becomes a problem for dealers and relative value firms.The expectational shock starts to be realized and there is a cash flow stress in the real economy. This will lead to credit rating downgrades. Finally, there is the problem of refinancing stress. Firms cannot roll their maturing debt or only borrow at much higher rates.

Central banks and government may use their powers to offset the different stresses. The response will be measured versus the stresses faced. As we move further down the stress spectrum, more support may be necessary to stop a cash flow or refinancing problem. Each Fed response can be mapped into the stress. For example, Treasury buying offsets one-sided trading. Repo funding serves to stop the limits of arbitrage and liquidity risk. The commercial paper facility helps with refinancing risk. 

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