Risk Management Part II
As domestic markets were becoming increasingly efficient, investors began searching for excess return by expanding their holdings into more esoteric types of derivatives, illiquid securities, non-dollar and real estate debt, emerging market bonds, and other asset classes. While creating (at least in theory) diversification benefits on the portfolio level, this presented investors with "unfamiliar combinations of risk,"
As a result, traditional concepts of financial diversification (holding portfolios of assets with uncorrelated systematic sources of risk) are becoming undermined by common risk management practices of progressively similar capital pools. The use of similar risk management techniques by an increasing proportion of the financial system (asset managers, hedge funds, mutual funds, banks, insurance companies, etc.) leads, in times of crisis, to similar reactions by market participants to financial catastrophes:
Similar goals: In times of turmoil, investors try to reduce total risk per unit of capital and/ or raise cash to cover margin calls.
Similar response: First, they naturally attempt to sell illiquid positions. After discovering "no bid" (huge and unrealistic spread widening on thin trading) for illiquid securities, liquid positions have to be sold, regardless of which market they are in. 4 This phenomenon may create correlations among asset classes that are fundamentally uncorrelated.
Vicious circle of liquidity: Lenders increase "haircuts" on illiquid leveraged positions, thus forcing additional liquidations, further depressing the value of illiquid positions, and, in turn, exacerbating margin calls. At the same time, dealers become reluctant to take long or short positions of any significant size and widen bid/ ask spreads.
Model risk: Reliance on similar quantitative models can create dangers of its own since the behavior of financial markets changes fundamentally in times of crisis"
Risk Management Part I
Blackrock: Risk Management Approaches
As a result, traditional concepts of financial diversification (holding portfolios of assets with uncorrelated systematic sources of risk) are becoming undermined by common risk management practices of progressively similar capital pools. The use of similar risk management techniques by an increasing proportion of the financial system (asset managers, hedge funds, mutual funds, banks, insurance companies, etc.) leads, in times of crisis, to similar reactions by market participants to financial catastrophes:
Similar goals: In times of turmoil, investors try to reduce total risk per unit of capital and/ or raise cash to cover margin calls.
Similar response: First, they naturally attempt to sell illiquid positions. After discovering "no bid" (huge and unrealistic spread widening on thin trading) for illiquid securities, liquid positions have to be sold, regardless of which market they are in. 4 This phenomenon may create correlations among asset classes that are fundamentally uncorrelated.
Vicious circle of liquidity: Lenders increase "haircuts" on illiquid leveraged positions, thus forcing additional liquidations, further depressing the value of illiquid positions, and, in turn, exacerbating margin calls. At the same time, dealers become reluctant to take long or short positions of any significant size and widen bid/ ask spreads.
Model risk: Reliance on similar quantitative models can create dangers of its own since the behavior of financial markets changes fundamentally in times of crisis"
Risk Management Part I
Blackrock: Risk Management Approaches
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