Financial Econometrics and Empirical Market Microstructure

Cycle of Hidden vs. Visible Risk

Hidden risk suddenly becomes visible risk similar to the way a spring’s potential energy is released as kinetic energy. Until February 2007, banks were considered rock solid (despite record debt and subprime concentrations, not to mention warnings from luminaries like Roubini and Shiller). Visible risk (volatility) was at historic lows, as tension mounted below the surface. HSBC’s February 23 loss announcement was a classic Black Swan, and triggered a jump in volatility that spread from subprime to equities on February 27. Even though risk would keep escalating for the next 2 years, both the February 23 bond outlier and the February 27 equity outlier would remain the largest surprise. Surprisingly, though, both equity and bond markets dismissed these outliers as markets recovered after each selloff. Subprime bonds started their bear market only after the July ratings downgrade, and equity markets kept bubbling until their October 2007 peak.[20]

By the time the market hit bottom on March 6, 2009, volatility had been at sustained record levels and only gradually started to decline. The market’s assessment of risk and return was, in effect, exactly the backward. As NBIM’s founding CEO Knut Kjaer notes: “The biggest pitfall in investments is herd behavior. Large gains in performance can be achieved by investors with ability to consistently act contrarian” (Kjaer 2011).