Market for Risk: Engineered Ascent or a Suspended Decline

Walrus propounded the foundation of the General Equilibrium theory, the basis for modern day Economics that explains how economies work; the fact that supply must match demand and be in equilibrium is the fundamental basis for the Arrow-Debreu model to work. Or to put it differently, the two sides if they do not match, price is the only plausible signal that makes allowance for adjustments to be made on both sides to bring equilibrium. If this was not the case, we would have seen the world of Economics crumbling with very complex models with even more complex mathematics trying to explain how economies work that no one would have been able to comprehend.

That does not mean attempts to question this equilibrium theory never happened, but it made matters far more difficult to comprehend. Economists have so far kept it simple on the outside, while complexities were part of the underlying model. Plethora of products, some of them supremely differentiated have changed the equation as supply rarely matches demand and is hugely in surplus. Many would find in awe that most price movements reflect an engineered ascent or a suspended decline at play, thanks to the market for risk, which steps in with a range of products.

“Stability is destabilizing”, Minsky’s 1992 ‘Financial Instability Hypothesis’ is on the other hand a reminder that the principles of general equilibrium cannot ignore the effects of financial relations, the liability structure of the households, the government and the system’s ability to re-finance debt (ability to roll over financial positions) and the incentives designed to balance risks.

Walrus and his world of equilibrium, was simple. It did not have animal spirits that would topple the apple cart. Even Arrow-Debreu model did not factor in the current deeply distorted incentives that make allowance for extreme risks to be taken, which makes the equilibrium be set in a constant environment of stress, making prices volatile or sideways sometimes and the predictability of equilibrium is always in a state of doubtful stupor. The low interest rate regime makes the market for risk ripe for further speculative activity to take shape; the equilibrium is never straightforward as sweeping volatility takes over.

The financial world revolves around pro-cyclical risk, which means as the business cycle moves through the upturn all investments (speculative included) are made in tandem. We have also seen that the government fiscal policies are also pro-cyclical, which means that the government spending increases as the government revenues increase through the upturn. Central banks actually holds the key to act as the stabilizing influence by modulating interest rates so that bubbles could be avoided, but bubbles are hardly things that can be seen, they happen because no one notices them.

The stabilizing influence is played by many investors, the institutional investors are one of them; the futures market is also supposed to play the role of stabilizer, as the producers become net long, the speculators are net short to balance. So the speculators also play the role of stabilizers, financial speculation is in fact stabilizing, the long positions taken by financial investors have enabled producers to take short hedging positions and hold larger inventories, which increases current spot prices and should stabilize prices going forward.

But there is a subtle problem that speculative capital is a scarce commodity, so if speculators have ample capital, they are willing to cheaply take the opposite side of producers’ hedge-motivated futures demand, while if speculator capital is scarce, the compensation required (the futures risk premium) is large; thus a decrease in the futures risk premium leads to an increase in the spot price as producers are willing to hold more inventory when the cost of hedging is lower.

Current scenario actually mimics the capital-limited speculative risk scenario and with collateral getting squeezed out, the spot prices have shrunk to the disadvantage of the producers.

The institutional investors are the most potent stabilizers in this market, but given the complexion of their profile, it is the pension funds and insurance companies that hold the bulk of the portfolio. The current low interest rate regime actually impacts them the most, so the extent to which they would be able to play a stabilizing role is severely in doubt.

The OECD Journal- Volume-1 of 2011 clearly talks of the impact of protracted low interest rates, “they impact pension funds and insurance companies by affecting re-investment returns on their fixed-income portfolio. If low interest rates are expected to be permanent, lower interest income in particular will impact insurers with long-term liabilities and shorter-term assets. To the extent that lower interest rates reflect a lower-growth environment, returns on investments in general – and equities in particular - would also be expected to be lower. Consequently, pension funds offering defined-benefit promises and life insurance companies that have sold products with high-return guarantees may have difficulty fulfilling these promises.”

At low interest rates the problem for pension funds is to estimate the discounting rate for future liabilities; at ultra-low discounting rates the net present value of future liabilities zoom.

The so-called stabilizers would have little option but to move into riskier territory. The market for risk therefore would have even greater incentive to take risk than to stabilize. All of this would need a horrid injection of constant liquidity, and at very low interest rates. Such injection of liquidity has been continuing for almost seven years now and just when everyone thought it is time to take the step out of the gas, the global data showed other lines of worry.

The market for risk, estimates its risk position through a number of instruments, VAR (Value at Risk) or ES (Expected Shortfall) are two of the potent ones. These are connected with more than one of the intrinsic parameters, of which interest rates are just one. The ability to diversify, therefore assumes far deeper attention, but as too much has already moved in there are not too many left unexplored.

The market would need new avenues for capital allocation, new unexplored supplies, like E-Commerce; this is not a zero sum and therefore this is net addition to the economies.

But as with all basic laws, businesses must return capital at the end, market for risk assumes that without any hesitation.