By Anita Hawser
State Street’s Will Kinlaw
Stress testing risk models and investment portfolios for extreme market events has certainly come into vogue in the wake of the financial crisis. Banks’ risk models were criticized for focusing too much on particular risk calculations and using historical data that did not accurately reflect the likelihood that extreme market events could occur. “One of the most valuable lessons learned over the last few years of market turbulence is that traditional portfolio construction techniques cannot comprehensively assess the full amount of risk inherent in a portfolio,” says Will Kinlaw, managing director and head of portfolio and risk management research at State Street Global Markets.
To help investors and corporations fully assess their risk profile, State Street has devised what it calls the turbulence indices, which measure the “unusualness, or turbulence” of market behavior on a daily basis. Each of the indices provides a single daily measure of turbulence based on the “abnormality” of its constituents’ returns on that day. The indices cover US and European equities, currencies, US fixed income securities and other global asset classes. State Street’s assessment of “unusualness” involves calculating how far from average a particular variable has moved.
By measuring the turbulence caused by unusual performance of a single asset or “extraordinary interactions” in correlations between assets on any given day, State Street says, investors can more effectively manage portfolio risk and build financial models that are better able to withstand extreme events. “Turbulence indices go a step further from traditional volatility measures by identifying periods in which assumptions about correlations between investments—as well as their volatilities—should be revisited,” Kinlaw explains. “The indices can be used alongside other measures of volatility to better manage current portfolios and prepare for additional instability in the market.”
Standard models may not take extended periods of market turbulence into account, and as market turbulence historically has proven to be persistent, State Street says, patterns of turbulence can be predicted enabling investors to better manage returns by scaling risk exposure to the assets affected.