Not even an illusion of safety

by James

Looking for the illusion of safety, there’s no such thing as a safe anything anywhere. In terms of the financial system and capital adequacy, and say pricing models like the CAPM and/or Black-Scholes, the risk free rate is an artificial construct based on a (financial) economist’s premise that such a thing exists. As far as the GFC is concerned, it wasn’t anything to do with the traditional idea of a ‘safe’ asset so much that financial engineers could create a proxy in their CDOs or CLOs or the like that the ratings agencies could find a tranche that they could label as ‘risk-free’. The subsequent problem that made things so much worse was that these assets on that basis were then able to permeate through the financial system.

Certainly gilts and US treasuries are ‘risk-free’ in the traditional sense of the word, in as much as their holders are as guaranteed as is possible to receive coupon and principle according to the terms of the bond, but that doesn’t make them a safe asset.  For one like any other financial instrument their price varies, meaning there’s no guarantee you’ll receive what you paid when you come to sell them. Equally given the difference between real and nominal rates of return, the effect of inflation on the value of money means that the purchasing power of your asset may well deteriorate.

The idea that gold has anything to do with this, creating so called ‘safe assets’,  is just ridiculous. Gold is a commodity that like any other has value as a means of exchange and as an investment. In some cultures it may be seen as a store of value, but this tends to be where there’s a requirement for a tangible, portable or fungible means of exchange, but at the same time they are also aware of the relative purchasing power of money.

The whole conception of ‘safe’ or ‘risk-free’ with regard to assets is as much a manipulable, sales tool used across the financial community by bankers, economists, academics etc as any other, and needs to be treated with commensurate scepticism. The idea of a requirement to satisfy demand for such an asset is discussed here.

Equally, this post describes how negative rates of return can still be seen to constitute a safe asset.

Finally, it’s quite apparent that the search for safety is definitely not ubiquitously responsible for creating asset price bubbles. While this could well have a lot to do with the current ‘bond bubble’, I’m not sure how anyone could describe the dot com and irrational exuberance of the late 90s as having anything to do with it.

Comments gratefully received and maybe more to follow.