Saturday, September 9, 2017

REPOST: Risk-on, risk-off trading

Thursday, October 31, 2013

Risk-on, Risk-off trading

In our chapter 9 video, we illustrate how Vanderbilt Treasurer made money by selling risky assets and buying less risky ones when risk premia (the extra return investors receive for investing in risky assets) moved to historic lows.  He correctly reasoned that investors were ignoring risk in search of higher return, so when risk premia widened, in 2008, the price of risky assets fell relative to their less risky counterparts.  In the jargon of finance, this is known as a "risk off" trade.

We can illustrate risk-off trading, uusing Don Marron's "history of the European Union in one simple chart" below. It shows the premia that the Southern European PIIGS (Greece is in orange) had to pay to borrow money.

In 1995, for example, Greece (in orange) had to pay 18% to borrow money, representing an 11% premium over Germany's (in red) 7% rate.  The risk premium disappeared in 2002 when Greece joined the EU.  In 2008, the risk premia re-appeared, as the interest rate on Greek debt rose to 16%, a 12% premium over Germany's 4%. 

From investopedia:

...During periods when risk is perceived as low, risk-on risk-off theory states that investors tend to engage in higher-risk investments. When risk is perceived as high, investors have the tendency to gravitate toward lower-risk investments.  ... The 2008 financial crisis was considered a "risk off" year, in which investors attempted to reduce risk by selling existing risky positions and moving money to either cash positions or low/no-risk positions, such as U.S. Treasury bonds.

If you can anticipate changes in risk premia, you can make money:

  • A prescient "risk-off" trade would have been to short Greek debt and buy German debt in 2007, and sell in 2011.  
  • Conversely, a prescient "risk-on" trade would have been to buy Greek debt and short German debt in 1995, and sell in 2001.

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