Taming Global Village Risk

Abstract

Asset price bubbles build and burst today much as they have since modern capital markets first evolved some 300 years ago. In recent decades, although the real economy has become less volatile, the financial markets have not; they remain volatile and unpredictable. Exploring the driving forces behind market volatility provides investors a basis for an effective response in dealing with market risk. Markets are, in effect, complex adaptive systems. They are composed of a great number of decentralized decision makers who are continually digesting information and interacting in unanticipated and nonlinear ways. That markets are complex adaptive systems has critical implications for how we think about and manage investment risk. In risk management, we must focus on the market mechanisms driving capital markets to higher volatility, including the emotions of investors, complexity of adaptive markets, and advances in technology and mathematical modeling. Improving risk management means finding new tools to measure the interconnectedness of markets plus the total amount of systemic risk, leverage, and liquidity in the markets. With improvements in risk management, investors and regulators will be better equipped to mitigate the market volatility that often culminates in financial market instability.

TOPICS: Portfolio construction, in markets, CLOs, CDOs, and other structured credit