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Futures Trade Desk- Market Risk 101

Client Note

Market Risk 101

In the world of instant reward and low attention span the use of risk analysis has become prevalent in daily main-stream media reporting. Risk, and the consequent buying or selling of global asset classes, has become a daily phenomenon rather than a weekly review little more than a decade ago

In its natural stance the financial market has three major attitudes towards risk, and models its behavior and actions according to risk outlooks. The three are; risk aversion, risk tolerance, and risk neutral. 

Aversion

Risk-aversion is characterized by investors selling assets considered speculative in nature such as equities (S&P 500 global benchmark), and swapping them for the relative safety but low-yielding bond market (US Treasury global benchmark). 

Risk-aversion can be seen relatively easy; commodities decline as investors consider that consumption will slow, while S&P 500 equity Futures head lower. 

In the currency market, risk-aversion strengthens the dollar (NYSEARCA:USD), as investor sell foreign denominated assets to buy USD-based Treasuries. Bear markets are characterized by risk-aversion phases, and are where higher yielding currencies (those with an economy offering higher 10-year interest rates than others) are sold the most. 

Tolerance

The risk-tolerance phase is seen when bonds and Treasuries are sold as investors look for higher yields, and are willing to fore-go guaranteed rates of return for speculative investments. In periods of relative calm and positive macroeconomic outlooks traders abandon the safety of the bond market and invest capital in stocks, commodities, and higher-yielding foreign currencies. 

In this phase of trade the USD is sold in-line with USD-based Treasuries, and equities are bought. Bull markets are characterized by risk-tolerant phases and in this period S&P futures head higher, together with AUD, CAD, and EUR currencies. 

Neutral

In most cases, risk-neutrality happens when the financial market moves sideways, unable to break decisively and hold in either direction. This period is characterized by a redistribution period, where investors shift their assets between various financial instruments to prepare for the next phase of risk aversion or tolerance. 

The shifts in sentiment, participation, and momentum, are not just happening session-by-session; they literally happen hour-by-hour. Sentiment is empowered by the relentless flow of automated trade that triggers as a contingency play when each regional market accepts risk neutrality. 

A sideways moving market tends to be the most volatile, as price channels are traded and fair value sought at each regional market open and close. The last quarter of 2011 has been a risk neutral period, with equity and interest rate markets unable to attract enough volume to make a stance on risk. Risk-neutral conditions allow currency markets to spin their wheels each day as dollar values are disseminated.

2012

It would seem that 2012 will begin with a neutral outlook on risk, but that may very quickly change as earnings season and a raft of red-flag economic releases hit the wires.

 



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