loans and money

Within such a cycle, there is obviously a substantial amount of intraday and intraweek volatility, reflecting swings in market sentiment. Traditionally, economists have either ignored such short- term periods or suggested they could not be predicted. While flow and technical analysis have done much to dispel such a view, recent work on the relationship between “risk appetite” and asset prices has made a real breakthrough in terms of being able to predict those short-term swings in sentiment and in turn how they affect currency and asset prices. Risk appetite or market sentiment are not easily definable concepts given that what these are focusing on is the investor’s willingness or otherwise to invest — which is not always based on logic! Despite such difficulties, the private sector has over the past few years been hard at work creating “risk appetite indicators” to measure overall conditions for risk tolerance across currency and asset markets. Within the investment banks, JP Morgan created its “LCPI Index” Bank of America has its “Global Hazard Indicator” and Salomon Smith Barney its “Instability Index”. For the purpose of an example, we will focus on the Instability Index. The index was originally created to track levels of risk appetite or conversely “instability” for fixed income investors. However, because it uses cross-market indicators for this purpose, we can also use it for managing and trading currency risk.
Risk appetite has become an increasingly important concept, not just because of the need to create more accurate models for forecasting short-term currency moves, but also because the last few years have shown a marked pick-up in cross-asset market volatility. Indeed, one can go as far as to suggest that as the globalization of capital flows has proceeded, so volatility has increased. Risk appetite is essentially a capital flow event and its relationship is directly proportional to the size of capital flows involved. For this very reason, just as capital flows across borders have grown exponentially, so the degree to which capital flows affect currency markets has grown proportionately. A crisis in one country is no longer isolated but is transmitted instantly around the global financial system. Investors who face losses in that one market may seek to take profit on other positions in order to offset those losses, thus creating a domino effect in hitherto unrelated markets.
Extreme bouts of cross-market volatility such as were seen in the wake of the ERM, Mexican and Russian currency crises prompted interest in creating risk appetite indicators which, if not predicting actual crises themselves, would at least be able to predict significant moves in terms of general investor risk tolerance. For this purpose, categories or levels of risk tolerance also had to be created. The three generally accepted categories within most such risk appetite models for this purpose are:
Risk-seeking
Risk-neutral
Risk-aversion
As the focus of the Instability Index is on market volatility and “instability” for the purpose of alerting investors to such bouts of unwanted volatility, these categories can be modified slightly for the purpose of focusing on such instability:
Stable
Neutral
Unstable

As with the supposed efficiency of markets, which does not actually work in practice, so there is the idea that supply and demand are completely independent of one another. If this were so, price trends could not exist because markets would instantly work to eliminate any supply or demand imbalances. The fact that this does not happen and that price trends do occur suggests that there are lags, sometimes substantial lags, before such imbalances can be eliminated. In addition, supply and demand are not completely objective concepts. Rather, at least in part, they reflect the views expressed by those market participants that make up that supply and demand. In other words, supply and demand are both cause and effect.
So much for the theory, what does this mean in practice? Actually, to a market practitioner, these ideas are relatively obvious. Currency interbank dealers know full well that particular flows will have more effect than others and thus will materially affect the supply/demand dynamics. Say a large multinational corporation transacts an end-of-quarter hedge in the Euro–dollar exchange rate. Granted, this is the most liquid currency pair in the world, but if the flow is large enough it may affect both current market pricing and future market thinking. Of course the term “future” means different things to different people. To the multinational, it means months at least if not years. To the interbank dealer transacting the flow in the market place it means minutes or hours at most. Currency markets are essentially flow-driven over short time frames, and therefore it is vital to understand the relationship between supply and demand dynamics.
Just as supply and demand are not independent of one another and are both cause and effect, so the relationship between “speculation” and economic fundamentals is also not just one-way. Economic theory requires that markets eliminate “speculative excess”, thus restoring equilibrium. However, we have already established that “equilibrium” is actually a moving target. If the “speculative excess” is the extent to which markets diverge from equilibrium, then that “speculative excess” is also a moving target. Finally, the presumption of economists is that economic fundamentals drive market pricing and thus to an extent speculative excess. Even if we accept this, it has also to be acknowledged that speculative excess can in turn affect economic fundamentals. This is best proven by example.