Risk Avoidance and Market Fragility

Abstract

Products that promise protection from the risks of investing can contribute to market fragility.

The era of “stocks for the long run” is over. Risk, dormant through much of the 1990s, has been rediscovered, and there is no shortage of experts willing to share their wisdom on how to stomp it out. But is there such a thing as being “too safe”?

When products purporting to “insure” against declines in broad financial markets attract large numbers of investors, the financial institutions offering such products are exposed to significant amounts of systematic risk. They frequently control their exposure to this risk by purchasing options or by replicating options via dynamic hedging, buying the underlying asset as its price rises and selling as its price falls. The dealers from whom options are purchased control their own exposure by either buying options or replicating them. Financial institutions’ ability to “insure” themselves against the insurance products they have sold is thus dependent on the presence of counterparties willing to sell them options or, equivalently, to take the other side of their dynamic hedging trades. As more and more investors demand insurance, however, insurers may face increasing difficulty in finding counterparties. Furthermore, more insuring is likely to lead to more trend-following dynamic hedging, which can exacerbate market volatility. As volatility increases, the demand for insurance may increase, heightening the demand for options and thus the amount of option-replicating trades, leading to even greater market volatility.

When market prices fall, the selling required to replicate an option on the market may overwhelm the willingness of other market participants to buy, creating a liquidity crisis. In such an event, the trades needed to replicate options will not get off at the prices required to guarantee the insured value and the trades will have to be executed (if at all) at much lower prices. The “insurance” can fail. When that insurance underlies the insurance products sold by a financial institution, those products, along with the institution itself, can fail. What is more, because of the linkages between counterparties, one institution’s failure can lead to systemic failure and broad economic disruption. Insurance products have taken financial markets to the brink before, in the 1980s with portfolio insurance and in the 1990s with the collapse of Long-Term Capital Management (LTCM).

In both cases, the market could not accommodate the amount of trading required to “insure” supposedly “riskless” products. Market prices gapped discontinuously. Insured investors could not get their trades off at the prices required to guarantee the insured values. Thus, portfolio insurance failed to provide the promised protection. LTCM incurred substantial losses on trades that had been designed to be relatively riskless. Furthermore, the aftershocks of the portfolio insurance and LTCM debacles were felt globally. In both 1987 and 1998, markets effectively had to be bailed out by the U.S. Federal Reserve Board, which provided liquidity in the wake of both crises and also orchestrated the rescue of LTCM in 1998.

With traditional insurance, risk of loss is essentially shared by many policyholders, with the insurance provider acting as intermediary. Those who buy “insurance” against a stock market decline, however, are really shifting this risk onto the insurance provider. But who is the risk bearer of last resort? It may be the taxpayer, if the government decides that the firms that offered these products are “too big to fail.” Often, it is investors in general who bear the risk, in the form of the substantial declines in prices that are required to entice risk bearers back into the market. Ironically, products designed to reduce financial risk can end up creating even more risk.