Understanding The Risk On – Risk Off Phenomenon

Risk on/risk off refers to a phenomenon that reflects the mood or 'sentiment' of market participants. We can distinguish between two different types of market sentiment:

• Risk appetite - this is when market participants believe in the good performance of the global economy, and the expected improvement of the state of the economy makes them "hungry" for risk.
• Risk aversion - this is the opposite of risk appetite, when investors believe that the global economy will worsen, and they are therefore reluctant to take a risk and are looking for safer investments.

Market sentiment can sometimes seem like it is constantly swinging, with risk appetite quickly being transformed into risk aversion, and vice versa.

In search of higher returns: Risk-on investments

An improved economic outlook tends to improve market sentiment and increase investors' appetite for risky and higher yielding assets. In forex, these assets include the euro (EUR), British pound (GBP), commodity currencies such as the Australian dollar (AUD), Canadian dollar (CAD) and the New Zealand dollar (NZD); as well as other exotic currencies like the Mexican peso (MXN) and the South African rand (ZAR). These risk-on currencies tend to appreciate when market sentiment is positive, as market participants put their money into more risky, but also more lucrative investments.

In search for safety: Risk-off investments

In contrast, when uncertainty grows and pessimism dominates the market, investors look for safer places to store their wealth. Traders look for investments which are expected to bring them smaller but safer returns. Some buy government bonds, which are guaranteed by the state, or gold, while others look to the so-called 'safe haven' currencies. Thus, we often see that a heightened risk aversion spurs a higher demand for the Swiss franc (CHF) and the Japanese yen (JPY). It is also worth noting that since the beginning of the most recent financial crisis, in addition to the CHF and the JPY we have observed an attraction to another currency - the US dollar (USD).

Which investments are risk-on and which are risk-off?

Investment asset	Risk-on	Risk-off
Currencies	EUR, GBP, CAD, AUD, NZD, ZAR, MXN	JPY, CHF, USD
Commodities and Metals	OIL, BRT, HEO, GAS	XAU, XAG
Securities	DAX, FTS, NDQ, SPI	Government Bonds

What determines the status of an investment asset?

The features of currencies depend strongly on their countries' economies, or more precisely, on their cyclical and structural characteristics. Some nations are relatively sensitive to the global economic outlook while others are less impacted. For instance, Canada, Australia and South Africa export large amounts of natural resources, and any slowdown of the global economy that triggers a weaker demand for oil and raw materials has a large impact on them. For this reason, during times of negative market sentiment the CAD, AUD and ZAR are under pressure and are broadly sold off as investors move their assets to safer instruments.

On the other hand, safe haven currencies are more stable and reliable. They are a store of wealth at times of uncertainty and eroding market confidence. It takes a long time to build such a reputation. Countries with safe-haven currencies have the following characteristics in common:

· Long term track record of inflation control

· Long term track record of control over public finances

· Current account surplus

It is worth noting that the investment status of a particular asset is likely to change over time. All traders should therefore follow the financial markets for any new developments. In times of panic, as safe haven countries' currencies appreciate due to capital inflows, their governments may decide to intervene and stop the appreciation, and protect their export industries. Usually, these interventions are implemented to curb speculation on the particular safe haven currency, and investors start looking for alternative safe investments. Most recently, investors have turned towards the Norwegian krona (NOK), and the Swedish krona (SEK), amongst others.

Are risk-off assets risk free?

Many investments guarantee a safer return, however assets with zero risk do not exist.

Gold is a hedge against inflation and store of value during economic and political instability, but it is also highly volatile which increases its risk. The Swiss franc recently experienced an exchange-rate floor against the euro whereby it was not allowed to fall below 1.20, slowing down its expected appreciation.

Given the various benefits and drawbacks of different assets, a successful investor should have a diversified portfolio that includes both risky and relatively safer assets. Depending on the state of the market sentiment, the proportion of safe to risky assets will vary and will depend on the investor's tolerance to risk. In periods of risk appetite, the investor may increase the share of higher yielding instruments, whereas during risk aversion, it may be prudent to transfer some capital to safer assets.

Written by Peter Dimitrov

Easy Forex

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.