Via Brad Setser, Steve Johnson describes the recent sell-off in world markets:

The selling was largely driven by a sharp rise in volatility, with the Vix index, often referred to as Wall Street's "fear gauge" hitting a two-year high.

This increased the "value at risk" of leveraged investors such as hedge funds, forcing them to cut long positions. Many of the assets that had made the strongest gains this year, such as emerging markets, fell most sharply as a result.

This issue of VAR-driven sales on increasing volatility bring up a very general point about risk mitigation in financial markets: Any single risk-mitigation scheme widely adopted to reduce the risk of individual participants increases systemic risks to the market. Runs on banks, programmed stop-loss sales, and now sales at VAR thresholds are some examples of this that we've seen. All are dangers of risk management monocultures.

Dangers of derivative-based risk control are more subtle, because derivatives allow the party that would otherwise bear risk to hold their "insured" positions rather than scrambling for the doors. But if the bearers of transferred risk manage their exposures very similarly, then their collective behavior creates systemic risks that come back to bite holders of the underlying. For example, if bearers of credit risk in swap arrangements mechanically short the credit market to hedge risk as credit spreads grow, bond prices will fall and credit spreads widen just as surely as if uninsured bondholders had sold-off themselves. Derivatives allow for greater diversification and dispersion of risk, ideally to those who best placed to bear it. This probably does push back the thresholds at which dangerous risk-mitigation herd behavior kicks in.

But if the buyers of risk all turn out to look alike and act alike, if their tolerance for bearing risk is limited, if they have underpriced risk in tranquil times, then everybody had better watch out. Even for those who have trimmed exposure rather than assuming risk, derivative-based risk management, like diversification, can only protect against security or sector-specific risks, not against systemic risk. If everyone bearing any important category of risk has similar ("industry best practice") ideas about how to cut incipient losses, that's a source of systemic risk. Beware risk management monocultures.

Steve Randy Waldman — Sunday May 28, 2006 at 9:00am permalink
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