Insights

The inverted yield curve upended several banks. What will the inevitable snap-down do?

The US Treasury yield curve has now been more inverted for longer than at any time since at least the early 1980s, or when measured proportionately, for even longer. The US is now one of 36 countries with inverted yield curves, as central banks globally fight inflation. It is often said that inverted yield curves predict recession, but in fact they predict (with confidence) falling rates. Sometimes, falling rates are associated with recession, but that need not always be the case.

The volatility of the VIX Index has at times caused the impression that it is less than reliable as an indicator of risk. VIX futures and the volatility surface provide clearer information about the market perception of risk and should be used in conjunction with the VIX Index. The different movements of the VIX Index, VIX futures and of the volatility surface historically fall into four major categories that can be useful in understanding the level and length of equity market risk perceived in the options market.

With supply chain pressures, inflation, a possible recession, and a war, it is not surprising that options prices and implied volatility are up. It's like déjà vu all over again. As senior practitioners at Capital Market Risk Advisors (CMRA) with more than 30 years’ experience each, we’ve seen this movie before. Those who don’t learn from history are forced to repeat it.

As a quant who studied AI in the early 70’s and morphed into a derivatives pioneer/risk manager/ risk advisor, this article re quant funds in China attracted my attention. Several important points that we all know but sometimes need to be reminded:

1. “Say what you do and do what you say” is an essential component of the responsibility an asset manager owes to their investors that is not always respected

2. History does not always repeat itself nor should we assume it will

3. It is important to stress test how sensitive your conclusions are to your assumptions in addition to sensitivity to market moves

4. Liquidity matters and changes over time. Beware of “iceberg risk” where your positions might have copycats that impact your liquidity

We are pleased to announce that Peter Niculescu, partner of CMRA, has been invited as a keynote speaker at The Quant Conference Digital on November 6th, 2020. The Quant Conference is one of the largest quant conferences engaging the foremost thought leaders from finance and academia to discuss the future of the quantitative finance industry. The Quant Conference Digital is the first visual event and covers topics including “Legends of The Industry on The Role of AI in The Future of Investment Management", a keynote on "Risk manager versus virus", a panel on "The Age of Quant: Persistent Returns or Never-Ending Arms Race?" and much more.

Every crisis is an opportunity to learn and grow. Although history does not necessarily repeat itself, risk management flaws and weaknesses often do. To avoid making the same mistakes again, it is useful to reflect on lessons learned and in many cases re-learned.

To that end, we have conducted a survey of a select group of risk management professionals to tease out their reactions and conclusions to the events of 2020.

Liquidity risk is a key risk and has been a recent focal point for regulators, with increasing transparency and attention demanded by SEC Rule 22e-4 for mutual funds and by Basel III's liquidity requirements for banks. Meanwhile, market participants have a sense that asset liquidity may be deteriorating, but there is little agreement even on the definition of liquidity risk or on how exactly to measure it. It is clear, however, that asset liquidity risk is multifaceted and managing it is both an art and a science.

We explore some of the questions surrounding asset liquidity risk in our whitepaper.

Lehman Brothers filed for bankruptcy on September 15, 2008 and the subsequent Great Recession reached its peak in 2009. Because these were the biggest and most stressful financial events of the last 80 years, historical data from 2008 and 2009 form the basis for much of today’s risk stress testing. However, as the intervening years push us further away from 2008 and 2009, the Great Recession’s impact on risk metrics can start to recede.

Most financial services companies use stress scenarios that are based on historical data. For example, the 99th percentile adverse move over a 10-day period is a common cut-off for the development of stress scenarios. Notably, such a stress scenario is by definition no more severe than the 99th percentile.

CMRA has surveyed a variety of market participants and market observers on the margin regulations for uncleared swaps, which have been gradually rolling out since the fall of last year. Survey participants shared their thoughts on variation margin, initial margin, and ISDA SIMM.

• Variation margin compliance is on target to be completed by September 2017
• Requirements for margin to be posted in cash by larger counterparties raise funding cost concerns
• T+1 settlement in the US vs. T+2 in Europe is causing problems with collateral management and optimization
• Initial margin regulations are rolling out gradually but funding costs are already seen as high enough to push additional product types to CCPs
• Initial margin (based on a 10-day 99% move) is reported to be too high for relatively liquid product types and too low for large or illiquid swaps relative to risk