DIVERSIFICATION
For these reasons, the financial Figure 2: Commodity Correlations & Risk Aversion
system as a whole has become more sensitive to asset-specific and global liquidity conditions than it was in the past.
Risk On/Risk Off Post-Lehman markets are even
more integrated than before because of the highly uncertain public debt and growth prospects in developed countries that make trading based on fundamental approaches recede in favour of more behavioural approaches trying to anticipate the future direction of the herd. Since the end of the brief
The red curve depicts the evolution of a commodity index, whose weekly returns
are those of a basket of long positions in short-term metals, gold, agricultural and energy futures contracts. The black curve corresponds to an average of different normalized costs of risks (VIX, currencies implied volatility, corporate spreads, emerging spreads, sovereign CDS, banks’ CDS, spread between LIBOR and Treasuries yield).
Source: Riskelia
fund redemptions, refinancing issues in the wholesale funding market) prompts all players to deleverage their common positions in herds. The systematization of VaR-
based risk management systems is another factor inducing cross-asset class spillover effects: asset price turbulence (e.g. following a sharp fall in a given asset class) increases the estimated Value-at-Risk, hence commands liquidating the different assets in portfolio to comply with the pro-cyclical capital rules.
‘decoupling episode’ of August 2007- July 2008, investors’ attitude towards risky assets is best described by the so-called ‘risk on/risk off’ paradigm: in periods of optimism, investors manifest a high appetite for risky
assets, that they finance using the low-yield US dollar as a funding currency; this results in a decline of the US currency and a parallel increase of emerging currencies, equities, corporate bonds and commodities. When, for any reason, risk aversion surges, the positions are rapidly unwounded, leading to a liquidity dry-up and in turn to a brutal drop in the price of risky assets at the benefit of the US dollar. Commodities, even gold, have not been spared by this new
Figure 3: Responses to Increased Risk Aversion
trend. They are actually at the very core of the risk on/risk off switching machine. Figure 2 shows that, up to the massive deleveraging of August 2008, commodities have efficiently diversified the surges in risk aversion. The behaviour of the period August 2007-August 2008 is particularly interesting as commodities, contrary to equities, have been robust to the liquidity dry up of August 2007 and to the developments of the subprime crisis up to the summer 2008. However, from August 2008 onwards, commodities prices closely respond to the evolution of risk aversion: periods of relief are bullish for commodities whereas periods of fear are detrimental to them, as they are to the rest of risky assets. Figure 3 confirms that commodities, whereas they played a useful diversifying role in portfolio of diversified assets up to 2008, now behave similarly to other risky assets in episodes of large scale deleveraging.
Average responses of different risky assets to the increases in risk aversion.
The responses are calculated as the average asset returns on the weeks when risk aversion increases by more than a certain threshold (defined as the 90% quantile of risk aversion weekly variations). They are expressed in numbers of standard deviations. First period ends in Dec 2005, second period in July 2008.
Source: Riskelia 10 December 2010
Risk On/Risk Off or Bubble On/Bubble Off? Figure 5 provides a different perspective
on the risk on/risk off paradigm, showing that markets behave in fact more like a
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