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Multiplying Risks in an uncertain world: Moving away from the fundamentalsBy: Procyon MukherjeeZurichI chanced upon a brilliant article by R.Rajan, while I was going through the FY2008-09 AnnualReport of BIS (Bank of International Settlement), which referenced this article written in 2005.Unfortunately the whole world ignored the analysis he did about chances of increased risk withthe risk mitigation efforts launched by the financial instruments, CDS, Derivatives, et al.I have summarized his findings and those from the BIS paper as follows:1. The incentives to take "tail risks": The investment managers were actually selling in this casedisaster insurance to produce positive return most of the time as compensation for a very rarenegative return, since true performance could only be ascertained over a long period; they nevergot evaluated as the horizon fell outside the average fund managers' incentive time period. Chanet al had proved in 1999 that a hedged position can turn completely un-hedged when catastrophestrikes taking the Russian debt example. BIS paper proves that most distributions were notnormal distributions as envisaged by the experts and such fat tail distributions had higherpropensity of carrying tail risks.2. Herding: Originally Herding was meant to insulate against under-performing but that increasedthe ability to move asset prices away from the fundamentals (this has happened in stocks andcommodities and whole exchanges or indexes); the fund managers (who did not want to be partof the herd) who wanted to move the prices back to the fundamental were challenged with the upheal task of fighting against the enormous mass of 'herd managers' who were pursuing the trend,with no rationale what so ever.3. Incentives and Low Interest Rates: Excessive tolerance for risk in a low interest rate regime.With markets completely integrated this is a prescription for risk multiplication.With liquidity freely flowing in the markets, the chances of risk explosion is almost positivelyconfirmed by studies. The financial market explosion triggered by macro-economic imbalances(like current account imbalances, low interest rates and credit boom) and micro-economic factorslike de-regulation, incentives and risk measurement got the trigger from much higher risk takingthat was originally meant for mitigating risk taking efforts.Why did the discerning public, the corporate houses and their risk management cells fail todecipher that within the confines of this strategy of risk mitigation was embedded a much higherpropensity of risk as with crowding and bundling of products that made risk trading to be possibleand sometimes profitable as well, there was this high probability that when crisis would strike, likea pack of cards there would be no end in sight before bankruptcies would loom ?This apparent ignorance of the situation is well in evidence by the herding community who wereirrational par excellence when they drew money from the bank at high interest rates to invest instocks when the stocks were already over-valued (some of them are my friends in India, whereinterest rates are relatively high) or in mortgage products where the high prices already broke allbounds of rationality. In the root of this ignorance is the fundamental principle on which all stockmarkets thrive, if every man strikes the same belief as the collective, then every man eitherbelieves that the stocks should move up or move down. In the former case it helps to move it upand in the latter it brings it down. If every man thinks differently to the collective wisdom, hecounteracts to the cause. The environment created more positive connections to the collectivewisdom and helped to make the market buoyant. It was just the opposite of what supply anddemand curves would do in Classical Economics, the market moved away from thefundamentals.
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