RISK & CAPITAL MARKET EQUILIBRIUM

Risk Analysis is a proven way of identifying and assessing factors that could negatively affect the
success of a business or project. It allows you to examine the risks that you or your organization
face, and helps you decide whether or not to move forward with a decision.

Risk assessment is the name for the three-part process that includes: Risk identification.
Risk analysis. Risk evaluation.

The main four types of risk are:

 strategic risk - eg a competitor coming on to the market.

 compliance and regulatory risk - eg introduction of new rules or legislation.
 financial risk - eg interest rate rise on your business loan or a non-paying
customer.
 operational risk - eg the breakdown or theft of key equipment.

Top 10 Op Risks - 2022

 Talent risk.
 Geopolitical risk.
 Information security.
 Resilience risk.
 Third-party risk.
 Conduct risk.
 Climate risk.
 Regulatory risk.

Key Takeaways

 Risk analysis seeks to identify, measure, and mitigate various risk exposures or
hazards facing a business, investment, or project.
 Quantitative risk analysis uses mathematical models and simulations to assign
numerical values to risk.
 Qualitative risk analysis relies on a person's subjective judgment to build a theoretical
model of risk for a given scenario.
 Risk analysis is often both an art and a science.

Like any market in a free market economy, capital market equilibrium represents a point at where
supply and demand meet for investments. There are two equilibrium points in this market: one for
an individual investment and one for the aggregate of all investments bought and sold in this
market.

Capital markets are financial markets that bring buyers and sellers together to trade
stocks, bonds, currencies, and other financial assets. Capital markets include the stock
market and the bond market.
To help explain the forces that have generated the movements in yields observed in recent
decades, it is helpful first to construct a stylised model of the global capital market, shown in
Figure A.a There are two assets: capital (K), whose real return is uncertain; and government
bonds (B), whose real return is certain. In practice, of course, the return on government bonds
will be uncertain too because of the possibility of default, either de jure or de facto through
inflation, but for now it is helpful to put this to one side.

The overall supply of savings, or equivalently the demand for assets, (SS) that has to be held
in one of these two forms derives from the need for households to provide for their retirement
and to smooth consumption. It therefore depends on income, together with factors such as
expected longevity and retirement ages and whether there are unfunded pension schemes in
place that affect the need for savings. It will also be affected by the expected real return on
those savings, rp, which is an appropriately weighted average of the expected real return on
capital (rK) and the real return on bonds (rB). The supply of assets then derives from: the
demand for capital by businesses for investment (II), which, in turn, depends on factors such
as expected productivity and the required return on those funds, rK; and the supply of bonds,
which we take as exogenous. A possible equilibrium outcome is depicted in the left-hand
panel of Figure A, which is shown assuming that savings increase as the rate of return on
savings increases i.e. the SS curves slopes upwards (note that the analysis would be the same
if SS sloped downwards so long as it is steeper than II).

In order to see how the returns on risky and safe assets are related and move together, it is
helpful to look at the right-hand panel of Figure A. The downward-sloping line AA shows the
combinations of rK and rB that are consistent with overall asset market equilibrium (i.e. where
the total supply of savings is equal to the total demand for them), other things equal. It slopes
down because a lower required return on capital raises the demand for capital by businesses
but also lowers the overall supply of savings. To bring forth the necessary extra savings,
bonds would then need to offer a suitably higher return so that the overall expected return on
the portfolio is sufficiently high to return the market to equilibrium.

We then need to supplement this with another, upward-sloping, relationship (PP) that shows
the combinations of rK and rB that are consistent with portfolio equilibrium (i.e. that ensure
the allocation of savings between risky and safe assets is consistent with investors’
preferences and the respective supplies of each). In simple finance models, the spread of rK
over rB, also known as the equity risk premium, depends just on the statistical properties of
the returns on capital and the risk appetite of investors. But in arguably more realistic settings
with incomplete markets and financial frictions, a greater range of factors may become
relevant. In particular, government bonds may offer not only safety but also liquidity services
– for instance, banks and other financial institutions can usually offer high-quality
government debt as collateral for borrowing short-term funds from the central bank or other
financial intermediaries. In such cases, the premium may also be affected by asset supplies; in
particular, if bonds are already very plentiful the value of the extra liquidity services provided
by additional issuance will be quite low.b

We can use this diagram to identify the sort of factors that are likely to have driven yields in
recent years. In the 1990s, the yields on bonds and on capital fell together, roughly one-for-
one. That is consistent with factors shifting the asset market equilibrium schedule AA
inwards, so that rK and rB move along the portfolio equilibrium schedule PP in a south-
westerly direction. Summers’s ‘secular stagnation’ hypothesis, which focuses on a chronic
tendency of savings to exceed investment, produces just such an outcome.c

Since the early 2000s, however, it appears that the return on capital has been edging up at the
same time as bond yields have continued to decline, so that rK and rB have been moving in a
north-westerly direction. To explain this, one needs to invoke upward shifts in the portfolio
equilibrium schedule, PP, reflecting a shift in the demand and/or supply of assets in favour of
safe assets and away from risky assets (it is possible, of course, that the AA schedule has at
the same time continued to shift inwards).

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