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Recent Research: Highlights from April 2012

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"Defending the “Endowment Model”: Quantifying Liquidity Risk in a Post–Credit Crisis World"
The Journal of Alternative Investments (Spring 2012)

Abdullah Z. Sheikh and Jianxiong Sun

This article sets forth the proposition that liquidity risk may be optimized in an attempt to forestall or minimize the impact of a liquidity crisis. For a generic (but typical) endowment asset allocation, the authors find that liquidity levels between 6% and 14% are optimal, all other things equal, because 95% of the time, an allocation in this range would obviate situations in which a portfolio’s payout rate exceeds its liquidity pool. The framework also provides insights for tail-risk events involving a particularly severe liquidity crisis. For a generic endowment portfolio, the analysis indicates that in order to reduce the severity of a liquidity crisis to zero (i.e., eliminate risk completely), the allocation to fixed income would have to be around 35% (close to seven times the payout rate of 5%). Such an allocation would entail a very significant opportunity cost in terms of forgone returns based solely on a desire to mitigate extreme liquidity events (the proverbial “100-year flood”). In the authors’ view, reducing the likelihood of a liquidity crisis to below 5%, may be undesirable for all but the most risk-averse and least return sensitive endowments.

"Problems with Using CDS to Infer Default Probabilities"
The Journal of Fixed Income (Spring 2012)
Robert A. Jarrow

Using credit default swaps (CDS) to imply a firm’s or sovereign’s default probability is laden with difficulties, making the resulting estimate unreliable. This article exposes these difficulties using a simple analogy to life insurance premiums. An analogy is used because the logic is more easily understood in this context. The difficulties are unraveling the impact of risk premium, counterparty risk, market frictions, and strategic trading. Given a well-understood alternative to implied CDS default probabilities is available, actuarial-based default probabilities, banking regulations and risk management decisions should not be based on CDS implied default probabilities.

"Federal Market Information Technology in the Post–Flash Crash Era: Roles for Supercomputing"
The Journal of Trading (Spring 2012)
E. Wes Bethel, David Leinweber, Oliver Rübel, and Kesheng Wu

This article describes collaborative work between active traders, regulators, economists, and supercomputing researchers to replicate and extend investigations of the Flash Crash and other market anomalies in a National Laboratory high-performance computing (HPC) environment. Our work suggests that supercomputing tools and methods will be valuable to market regulators in achieving the goals of market safety, stability, and security. Research results using high-frequency data and analytics are described, and directions for future development are discussed. Currently, the key mechanism for preventing catastrophic market action is “circuit breakers.” We believe a more graduated approach, similar to the “yellow light” approach in motorsports to slow down traffic, might be a better way to achieve the same goal. To enable this objective, we study a number of indicators that could foresee hazards in market conditions and explore options to confirm such predictions. Our tests confirm that volume-synchronized probability of informed trading (VPIN) and a version of the volume Herfindahl–Hirschman index (HHI) for measuring market fragmentation could have indeed given strong signals ahead of the Flash Crash event on May 6, 2010. This is a preliminary step toward a full-fledged early warning system for unusual market conditions.

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