Systemic Liquidity Risk and Bipolar Markets: Wealth Management in Today's Macro Risk On/Risk Off Financial Environment

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Drawdowns and Tail Risk Management

It has been noted earlier that the widely discussed phenomenon of tail risk needs to be situated within the broader context of enhanced left tail dependencies, statistical terminology which illustrates the propensity for many asset classes to become more highly correlated as they all fall in unison when markets are experiencing crises. The propensity for the co-occurance of severely abnormal or left tail events, at the micro level of individual securities, is one of the defining features of a liquidity crisis. Moving to the macro level, and given the heightened degree of cross-sectional asset correlations discussed in Chapter 2, there will be a further accentuation of these left tail dependencies resulting in an increased risk of systemically threatening events. Taken together this combination became the signature of the financial crisis of 2008. However, instances of heightened left tail dependencies across multiple asset classes are certainly not confined to the 2008 crisis and can be observed at several other periods in financial history.

In this chapter I want to demonstrate the severity of drawdowns for a variety of securities that occurred both in 2008 and also during the bursting of the Nasdaq bubble in 2000/1. The longevity of adverse price developments leading to sustained drawdowns, which may include a fat tail event or trigger, but not necessarily so, needs to be distinguished from the notion of the isolated tail risk as a very ...