Wednesday, December 19, 2007

Central Banker Song

(Alea) The impact of risk management techniques on market dynamics is particularly enlightening with regard to the question of asset price overshooting. VaR calculations have become a crucial element of the standard approach used by market participants to evaluate the risk inherent in their market activities and to set up exposure limits.

Of course, central banks and financial institutions should continue to encourage the use of these instruments.

But, in times of financial turmoil, the growing use of sophisticated risk management techniques by financial intermediaries might have had the paradoxical effect of amplifying the initial shock, exhausting liquidity and contributing to contagion phenomena. Regardless of the intrinsic qualities of these risk management tools, we see that their growing use in the same fashion by all market participants may have produced pernicious effects.

Of course, central banks and financial institutions should continue to encourage the use of these instruments.

When market players rely on converging risk evaluations, they tend to take the same decisions at the same time, thus amplifying the initial shock to prices and trading volumes.

Of course, central banks and financial institutions should continue to encourage the use of these instruments.

All those factors have one consequence in common: they encourage homogenous behaviour and reactions to the detriment of the diversity that is indispensable to the smooth functioning of financial markets.

Of course, central banks and financial institutions should continue to encourage the use of these instruments.

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