Heisenberg’s Uncertainty Principle and Unintended Consequences in Finance

 

by Eben Maré, Associate Professor, University of Pretoria

Central banks have their jobs cut out for them! They measure a set of economic variables (such as inflation and employment), on a historical basis, and use those results combined with monetary policy to influence the future behaviour of the economy.

Without trying to complicate matters, we are reminded of the Heisenberg uncertainty principle in quantum mechanics which states, in layman’s terms, that we are unable to measure physical properties (for example, velocity and momentum) of a particle without affecting the particle.

In essence, our actions (today) will have an effect (potentially adverse) on our intended future outcomes. Targeting one specific economic variable will influence economic behaviour and outcomes.

Let’s discuss a highly relevant example – the US monetary policy. In response to the 2008 credit crunch, the US Federal Reserve embarked on its so-called quantitative easing programme in November 2008. As a consequence, Federal Reserve assets (a combination of mortgage backed securities, treasury notes and bank debt) peaked at USD4.5tr at the time the programme was halted in February 2014 (see Figure 1).

The combination of quantitative easing and low interest rates has had a clear benefit as shown in Figure 2. The unemployment rate has dropped and stock market volatility has realised approximately 10% annually, significantly lower than the long-term average of approximately 20%.

It stands to reason that the success of the US Federal Reserve’s quantitative easing programme has been the creation of confidence and stability.

In Heisenberg’s terms, the central bank’s policy actions (very low rates and quantitative easing) have created a stable economic environment but the financial market’s reaction (low asset volatility and extended asset valuations) could be seen as a side-reaction (leading to potential excess exuberance and risk taking).[[[PAGE]]]

"A man who carries a cat by the tail learns something he can learn in no other way"
Mark Twain

Many market participants talk about the ‘central bank put’, i.e., that central banks will act to protect asset prices; clearly, this is an unintended consequence of central bank actions! Financial markets have probably become too reliant on some form of government or central bank ‘backstop’.

We are by no means criticising the central bank actions – the purpose of the discussion is to highlight the so-called ‘tail risks’ which have arisen as a consequence of their actions. In the next section we discuss innovative financial strategies/product which could also create unwanted consequences.

Financial products and innovation

The seeds of the 2008 credit crunch were in collateralised debt obligations (CDOs), essentially repackaged bonds and loans which included so-called subprime mortgage debt. The housing bubble combined with the incentive system implicit in the securitisation process created a lethal cocktail – the end result was that the central bank had to step in to stem the rot.

The American Nobel Laureate and economist Robert Shiller aptly remarks that “every crisis contains the seeds of change”. Let’s look at some of the more recent financial innovations to ensure we understand their risks.

1. Commodity based exchange traded funds (ETFs).

Interest in commodity based products has surged dramatically in the last couple of years. One way to gain exposure to commodities is obviously by owning a basket of companies with exposure to specific commodities. Investors, however, seek to gain exposure to the underlying commodity directly. Such exposure can be gained by trading in commodity futures or through funds that hold commodity futures or exchange traded funds backed by the physical commodity or specific commodity based exposure backed by an institutional guarantee (so-called ETNs).

From an investor’s perspective the advantages of direct exposure to commodity based products are obvious. Commodities typically drive inflation and therefore provide an attractive investment opportunity. Furthermore commodity exposure serves to diversify investors.

One of the unintended consequences of commodity based investment products is that the traditional supply/demand dynamics of the spot-based commodity changes – the consequences thereof might be that commodity bull and bear markets become co-driven by equity-investor sentiment.

2. Risk parity based products.

Investors typically look at the risk of investments based on the realised volatility of the underlying assets. Equities have a long-term volatility of approximately 20% p.a. whereas bond volatility would be closer to 5% p.a. (depending on duration). Hence, a risk-parity portfolio would seek to overweight bonds and underweight equities to achieve equal volatility contributions from the two asset classes towards the overall investment.

Traditionally, equities have outperformed bonds; hence, to improve investment returns, a risk parity product would frequently employ leverage to increase returns.

"Our Crisis, after all, was largely a failure of imagination. Every crisis is."
Timothy Geithner

The problem with this type of strategy stems from the measurement of risk. Firstly, we measure the volatility of assets based on historical returns – as stated above, given the efforts of central banks in recent times, we have experienced a period of subdued volatility, especially in the bond markets. Events that lead to a spike in volatility would necessitate rebalancing of the strategy. The second question we need to answer is what we view as risk. Traditional finance would vote for volatility; however, investors should measure risk from the perspective of permanent depletion of capital – a very different concept.

One of the unintended consequences of risk parity based products, which are based on incorrect risk measurement practises and use of leverage, will be a false sense of safety for investors – not entirely dissimilar to the abuse of CDOs which led to the 2008 credit crunch.

3. Volatility based products.

It has been 27 years since the Chicago Board Options Exchange (CBOE) introduced its Market Volatility Index, commonly known as VIX. The index, in simple terms, is a measure of the S&P500 index option market’s expectation of stock market volatility over the next 30 days and has become a popular and widely-used reference for investors, analysts, the media and others. A rise in VIX is typically viewed as a ‘risk-off’ signal, for example.

As a consequence of the significant volatility experienced during the 2008 turmoil investors sought protection against surging volatility. The CBOE launched futures and options on VIX – products which have shown exponential growth since their launch.

To put the above in perspective recall the VIX is derived from the S&P500 option market; options and futures on VIX are therefore effectively a position on a series of underlying index options. Notice the compounding?

One of the unintended consequences of VIX-based trading is that investors have sought to curtail volatility in their portfolios; the effects of trading in higher-order VIX based products could threaten these desires at the time of the next crisis.

The cat’s tail and risk management?

The purpose of the previous section was not to slate financial innovation – we need to understand the changing financial landscape and new risks, albeit second order risks, that appear as a consequence of market participants (potentially unintended).

The essence of our argument is that so-called tail risks often appear as a consequence of seemingly good intentions. It is up to us, as managers of financial risks, to imagine disastrous outcomes as a consequence of hidden risks. Examples of hidden risks could be liquidity, leverage, over-confidence and incorrectly applied measurement metrics.