Mostly… fixed income and cross product eTrading

December 14, 2006

Priced for perfection?

Filed under: Uncategorized — holky @ 1:43 pm

So … while we’re all waiting for the funds to get their mandate to trade derivatives.. going back to the point that being able to understand the product is clearly the first step.

In a speech given 13/12 to a group of market participants, Sir John Gieve – Deputy Governor for Financial Stability, Bank of England – said that near-term risks to financial stability remain low. This view reflected benign macroeconomic conditions in the UK and globally, the strength of major financial institutions and the continued resilience of markets.  He did caution, however, that many markets appeared to be ‘priced for perfection’. Implied volatilities in equity markets, bond markets, credit markets and foreign exchange markets are low by historic standards. Risk premia are also at subdued levels. This seems to have encouraged risk taking outside the financial sector, for example, via leveraged corporate borrowing – a vulnerability previously identified by the Bank.

He suggested that while there were good reasons to believe there had been a genuine decrease in macroeconomic volatility, some of the fall in financial market volatility might be driven by the popularity of derivative strategies that amount to selling insurance against unlikely financial events. At a time when “risks in the wider environment are as great as ever…it is not clear to me that these risks are fully priced into the market”.

He concluded by stressing the importance of effective market discipline in current circumstances. “Given the rapid pace of innovation in financial markets and products and the low level of risk premia, investors may need to take particular care to understand the risks they are exposed to. More than in the past, they may need to ask some searching questions about how funds are being invested and how risks are being managed.” He suggested that one approach might be to put greater emphasis on stress test results as well as more conventional risk metrics.


1 Comment »

  1. Which raises the question. How do Long Only Funds gain this derivative experience?

    Develop it organically in-house? Can be risky & lengthy. Or do they buy it form Hedge Funds? Quality will be an issue as the top-notch hedgies, that the Funds would want, will cost and would be reticent to give up the “freedoms” experienced in that world.

    The development of e-Trading in interest rate derivatives can only help the Funds approach trading in a “safer” manner. At least eliminating some of the human error aspects.

    The problem is that vanilla swaps, CDS Indices etc don’t necessarily match what many Funds are doing now and will do going forward.

    Comment by waratah — December 20, 2006 @ 10:08 am

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