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Understanding Risk Regime Shifts And Flight To Quality
A high-volatility regime usually develops with a shock in one asset class, extends to other asset classes as investors worry about the consequences of the shock and, in a herding movement, snowballs into panic. At that point, returns from assets are inversely proportional to their riskiness, which is the opposite of expected behavior in normal times. This is illustrated in Figure 2, which compares the returns of various asset groups in the worst month of five major crises.
While equities were the worst performers in all these crises, bonds were also affected by the widening of credit spreads. In addition, assets that were previously negatively correlated may no longer remain so in a crisis, which significantly alters the diversification picture of a portfolio.
Figure 3 illustrates this effect by displaying the correlations between equities and bond premia in the last 10 years. In general, correlations are unstable and tend to change over time. However, during the periods of crisis as highlighted in orange, correlations generally rose substantially, which caused equities to become more correlated with bonds and hence reduced diversification benefits.
Since correlations can change quickly over time, particularly in crises, a well-diversified portfolio in normal times may still be subject to unexpected volatility in extreme circumstances. It is therefore also important for us to understand tail risk— particularly, how to estimate and manage it appropriately.
Modeling Extreme Events
A common statistic currently used to measure downside risk is value at risk (VaR). This statistic is defined as the maximum loss a portfolio is expected to incur over a specified time period, with a specified probability or confidence level. For example, if the one-week 99 percent VaR of a portfolio is 20 percent, then there is a 99 percent chance that the loss of this portfolio over a week is not more than 20 percent. In other words, there is only a 1 percent chance that the weekly loss would exceed 20 percent.
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