by Laurent GUERBY
Sat Jun 10th, 2006 at 02:39:24 PM EST
Via QuantLogic, a very interesting speech about hedge funds by Raghuram G. Rajan, Economic Counselor and Director of Research of the International Monetary Fund, some interesting bits:
I will argue in this talk that much of what is termed changes in "risk aversion" is likely to be changes in the structure of incentives and resulting behavior of investment managers--by "investment manager" I mean managers of financial assets ranging from those running insurance companies to those running venture capital and hedge funds. A primary driver of these changes is likely to be a change in the stance of monetary policy. Monetary policy thus might have effects outside the traditional channels, though the behavioral channel will amplify traditional effects. I will discuss what all this might imply for policy making.
For example, a number of insurance companies and pension funds have entered the credit derivative market to sell guarantees against a company defaulting. Essentially, these investment managers collect premia in ordinary times from people buying the guarantees. With very small probability, however, the company will default, forcing the guarantor to pay out a large amount. The investment managers are thus selling disaster insurance or, equivalently, taking on "peso" or "tail" risks, which produce a positive return most of the time as compensation for a rare very negative return.iiThese strategies have the appearance of producing very high alphas (high returns for low risk), so managers have an incentive to load up on them, especially when times are good and disaster looks remote.iiiEvery once in a while, however, they will blow up. Since true performance can only be estimated over a long period, far exceeding the horizon set by the average manager's incentives, managers will take these risks if they can.
Monetary Policy and Incentives
Thus far, I have highlighted four types of behavior--risk shifting, illiquidity seeking, tail risk seeking, and herding among investment managers. My conjecture, which needs to be tested econometrically, is that all these behaviors are amplified when interest rates are low (especially following a period of high rates), liquidity supply is plentiful, and both conditions are expected to prevail for some time. In reduced form, this behavior will look like an increase in risk tolerance. Conversely, if monetary conditions are expected to tighten substantially, we should see a reversal in this behavior, which would be attributed to increased risk aversion. Of course, part of this behavior would be accentuated by the genuine uncertainty surrounding any turn in monetary policy. Preliminary analysis suggests simple proxies for the risk aversion of financial markets in the United States, such as the VIX index, do seem to be positively correlated with the level of short-term interest rates, as with broad measures for liquidity.ivMoreover, the VIX explains a significant portion of the variation in emerging market debt spreads (see Kashiwase and Kodres (forthcoming)).
If verified empirically, however, this would suggest an additional "behavioral" channel for the transmission of monetary policy than the ones we are familiar with, the traditional money channel, the borrower balance sheet channel (Bernanke and Gertler (1995)), the bank lending channel (see, for example, Bernanke and Blinder (1988, 1992) or Kashyap and Stein (1997)), and the liquidity channel (Diamond and Rajan (2006)). I admit though that clever work would be needed to tell its effects apart from these other channels.
Nevertheless, from a policy perspective, this "behavioral" channel introduces new dimensions to thinking about monetary policy. For one, it could work entirely through institutions outside the banking system--through finance companies, insurance companies, pension funds, hedge funds, and venture capitalists. Equally important, it could have wider effects than through credit. In particular, it will affect asset prices, and could thus also amplify existing channels like the balance sheet channel, with the riskiest and most illiquid financial assets or borrowers affected the most. Finally, because emerging markets and developing countries offer risky and illiquid assets, there will be substantial spillover of industrial country policies to these markets.
Interest rates policy of ECB is something that isn't discussed much, but this speech echoes my intuition that the modern worldwide financial market - nearly anyone can buy and sell any financial instrument everywhere in the world with near zero transaction costs - has become a new phenomenon whose consequence haven't been fully sorted out yet.
Some other bits on Brad Setser's blog, with my comments about ... credit derivatives :).