Managing Risk in the Era of Dissonance

The era of dissonance is upon us. There are demography-related deflationary pressures as the post-WWII baby-boomer generation retires and debt-laden millennials struggle to pick up the slack. There are also technological disruptions – in retail, the growing evidence of the shift away from brick-and-mortar stores to internet shopping; in energy, the  phenomenon of  the shale revolution; in the consumption of news and means of communications, we have smart phones and social media that have fundamentally altered how individuals interact with each other and within society, just to name a few disruptive transitions that are in progress.

While the causes of economic and societal dissonance may have their roots in demographics and technology, their implications include the sharp political divisions being witnessed all over the world. We have the will of deeply divided electorates reflected in a variety of policy debates with implications for trade, immigration, health care, and tax policy, for example.

Our focus here is that the era of dissonance has been accompanied by major challenges regarding how market participants manage risk. Disruptive transitions in economics and markets have similarities with the concept in physics known as phase transitions. In a phase transition, there is a change from one state or environment to another. Think of water turning from a liquid into vapor upon boiling, or a liquid flowing smoothly (laminar flow) in a pipe and then flipping to a turbulent flow.

With phase transitions in physics, the chaotic activity is at the border or transition zone between the two states. In economics and markets, for example, the transitions driven by demographics and technology and reflected in a divisive political environment have meant that event risk is much more common along the transition or fault lines, and event risk may often overwhelm more slowly evolving economic fundamentals.

In this research, we wish to highlight and discuss a set of key challenges that emanate from the rise of event risk in the era of dissonance.

• Volatility may be a poor proxy for risk.
• High levels of uncertainty can co-exist with low levels of observed volatility.
• The rising probability of abrupt price movements dramatically complicates volatility analysis.
• Liquidity matters more than ever in an event risk episode.

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