Uncertainty/Volatility

A lot has already been written about the volatility of the financial markets in 2007 and the expectation that volatility in 2008 will be even greater. Perhaps a good place to start a discussion of this is the graphic display that was presented in the New York Times on Sunday, January 6, 2008 in the business section. Here is the link to this article titled “The Pulse of Uncertainty”.
http://www.nytimes.com/imagepages/2008/01/05/business/20080106_soapbox_graphic.html
The basic idea here is that volatility is created by uncertainty and uncertainty is connected with risk. But, we can be more specific than this. Economists define risk as volatility, or more explicitly as variance. And, it is important to note, that variance here not only relates to a decline in market prices, but also to an increase in market prices. That is, all movements in market prices are associated with risk and this is because all movements in market prices can be associated with uncertainty as to where the market prices should be. Not knowing where market prices should be means that we do not have sufficient information to predict, with certainty, where those prices should rest. If we had complete information concerning the determination of market prices we would know exactly what those prices should be. Hence, uncertainty arises because we only have incomplete information available to us and our decisions to buy or sell must be made in the face of this incomplete information. Thus, when the volatility (variance) of market prices increase, we can draw the conclusion that uncertainty has increased because market participants believe that they need (much) more information upon which to make their decisions concerning the future than they have.

The volatility of market prices can be observed, as in the New York Times graphic, but it is also argued that changes in the perceptions of risk by market participants should be reflected in the relationship of market prices themselves. For example, in the market for fixed income securities ( bonds), perceptions of changes in credit risk can be discerned from the spreads that exist between the interest rate yields of different classes of bonds of the same maturity. U. S. Treasury securities are assumed to be risk free, credit-wise. So the spread in yield between corporate bonds that are rated Aaa and U. S. Treasury securities of the same maturity provide us with an estimate of the difference in credit risk between risk free bonds and bonds issued by the most credit worthy corporations. Changes in this spread reflect a change in the market perception of the riskiness of the two types of issuers. Furthermore, one can look at the spread between corporate bonds rated Baa and those rated Aaa in order to see how market participants are judging the credit risk of these two segments of the market. One additional measure is the spread between yield on High Yield (or junk) bonds and the yield on Aaa corporate bonds. The crucial thing in all of these measures is not the spread itself, but how the spread is changing over time. As spreads change we need to try and understand what this is telling us about the perceptions of market participants in terms of relative assessments of risk.

A recent article in the Wall Street Journal by David Ranson, the President of H. C. Wainwright examines the recent movement in the Baa/Aaa spread. The URL for this article is http://online.wsj.com/article/SB119846436682348345.html . In this article Dave discusses the mess in the market for subprime mortgages and the securitized instruments created from them and examines why the Baa/Aaa spread had not increased until December. He argues that the concern over credit risk due to the subprime scare had not spread throughout the market until this late date. The data used come from the Federal Reserve System. The URLs for these data are: Daily http://www.federalreserve.gov/releases/h15/update/;
Weekly http://www.federalreserve.gov/releases/h15/.

An additional problem of financial markets needs to be mentioned, that of the liquidity crises. Liquidity crises are not uncommon and can be quite treacherous. A liquidity crisis is a short term affair and can result in the failure of one or more organizations. (The 1997 collapse of Long Term Capital Management (LTCM) is an example of what can happen in a liquidity crises and how companies can fail as a result of them.) The first component of a liquidity crisis is that financial assets must be sold and the market place knows that the assets must be sold. The second component of the liquidity crises is that market participants don’t know what market prices should be and these market participants just ‘go away’ and don’t return to the market until they have sufficient information about where market prices should be so that they can, with some confidence, come back into the market on the buy side. In essence, the market is in free-fall. What is needed is something to stabilize the market and this is often the Federal Reserve System. There must be a buyer, and in the case of the Fed, the central bank becomes the ‘buyer of last resort.’ But, as mentioned above, a liquidity crisis tends to be a short term affair unless the market fails to stabilize and the downward spiral becomes cumulative.

If a liquidity crisis does not occur during a time of financial distress it means that the markets are absorbing the problems faced by market participants and are adjusting to the new situation in a relatively smooth manner. That is, market participants are working things out. What is always hoped for is that markets will adjust incrementally thereby avoiding the discontinuities that result from a discrete decline in market prices that might come from a liquidity crisis.

Thus, although volatility has increased in the financial markets, indicating a rise in perceived market risk, so far the financial distress of certain market participants is being worked out as smoothly as possible and has not yet resulted in a liquidity crisis. This does not mean that we are out-of-the-woods, but it does give us some hope that the problems now being faced by financial institutions are being addressed and are being resolved even though that resolution may be quite painful. These adjustments must be made and must be made in a timely manner. We just don’t want the adjustments to result in a cumulative downward spiral.