Archive for the ‘Academic research & research papers’ Category

What explains the differences between rising stock markets and declining economic prospects?

July 10, 2020

Prof Robert Shiller in this Proj Synd piece:

The performance of stock markets, especially in the United States, during the coronavirus pandemic seems to defy logic. With cratering demand dragging down investment and employment, what could possibly be keeping share prices afloat?

The more economic fundamentals and market outcomes diverge, the deeper the mystery becomes, until one considers possible explanations based on crowd psychology, the virality of ideas, and the dynamics of narrative epidemics. After all, stock-market movements are driven largely by investors’ assessments of other investors’ evolving reaction to the news, rather than the news itself.

That is because most people have no way to evaluate the significance of economic or scientific news. Especially when mistrust of news media is high, they tend to rely on how people they know respond to news. This process of evaluation takes time, which is why stock markets do not respond to news suddenly and completely, as conventional theory would suggest. The news starts a new trend in markets, but it is sufficiently ambiguous that most smart money has difficulty profiting from it.

Central banks in parliaments: a text analysis of the parliamentary hearings of the Bank of England, the European Central Bank and the Federal Reserve

July 9, 2020

Nicolò Fraccaroli, Alessandro Giovannini and Jean-François Jamet in this ECB WP:

As the role of central banks expanded, demand for public scrutiny of their actions increased. This paper investigates whether parliamentary hearings, the main tool to hold central banks accountable, are fit for this purpose. Using text analysis, it detects the topics and sentiments in parliamentary hearings of the Bank of England, the European Central Bank and the Federal Reserve from 1999 to 2019.

It shows that, while central bank objectives play the most relevant role in determining the topic, unemployment is negatively associated with the focus of hearings on price stability. Sentiments are more negative when uncertainty is higher and when inflation is more distant from the central bank’s inflation aim.

These findings suggest that parliamentarians use hearings to scrutinise the performance of central banks in line with their objectives and economic developments, but also that uncertainty is associated with a higher perceived risk of under-performance of central banks.

It will be interesting to go through some of these hearings..

New Testament’s Matthew effect and modern finance: on the nexus between wealth inequality, financial development and financial technology

July 9, 2020

Jon Frost, Leonardo Gambacorta and Romina Gambacorta of BIS in this paper:

In the social sciences, the idea of the well endowed receiving further privilege, eg the rich getting richer, is often called the “Matthew effect” (New Testament Book of Matthew, 25:29). In economics, this effect is relevant particularly for wealth inequality. The effect could be amplified by financial development and technological advances that give investors access to better financial services or to assets with higher returns.

This paper analyses the role of financial development and financial technology in driving inequality in (returns to) wealth. Using micro data from the Survey on Household Income and Wealth (SHIW) conducted by the Bank of Italy for the period 1991-2016, we find evidence of the “Matthew effect” – a capacity of wealthy households to achieve higher returns than other households. With an instrumental variable approach, we find that financial development (number of bank branches) and financial technology (use of remote banking) both have a positive association with households’ financial wealth and financial returns. While households of all wealth deciles benefit from the effects of financial development and financial technology, these benefits are larger when moving towards the top of the wealth distribution. Still, the economic significance of this gap fell in the last part of the sample period, as remote banking became more widespread.


Evolution of Monetary policy framework in India: Mid-1980s to today

July 8, 2020

Prof Pami Dua in a recent paper in Indian Economic Review:

In 2016, the monetary policy framework moved towards flexible inflation targeting and a six member Monetary Policy Committee (MPC) was constituted for setting the policy rate. With this step towards modernization of the monetary policy process, India joined the set of countries that have adopted inflation targeting as their monetary policy framework. The Consumer Price Index (CPI combined) inflation target was set by the Government of India at 4% with ± 2% tolerance band for the period from August 5, 2016 to March 31, 2021.

In this backdrop, the paper reviews the evolution of monetary policy frameworks in India since the mid-1980s. It also describes the monetary policy transmission process and its limitations in terms of lags and rigidities. It highlights the importance of unconventional monetary policy measures in supplementing conventional tools especially during the easing cycle. Further, it examines the voting pattern of the MPC in India and compares this with that of various developed and emerging economies. The synchronization of cuts in the policy rate by MPCs of various countries during the global slowdown in 2019 and the COVID-19 pandemic in the early 2020s is also analysed.


Comparing the financial centres of Tokyo, Singapore, and Hong Kong in FX Markets

July 8, 2020

Washimi Kazuaki and Kadogawa Yoichi of BOJ in this research article:

In recent years, turnovers of Foreign Exchange (FX) trading in Singapore and Hong Kong SAR have outweighed those of Japan, and the gap between the two cities and Japan continues to stretch. The two cities consolidate trading of G10 currencies by institutional investors and others by advancing electronic trading.

Additionally, a number of treasury departments of overseas financial/non-financial firms are attracted to the two cities, contributing to the increasing trading of Asian currencies in tandem with expanding goods and services trades between China and the ASEAN countries.

this juncture, FX trading related to capital account transactions is relatively small in Asia partly due to capital control measures. However, in the medium to long term, capital account transactions could increase, which would positively affect FX trading.

Thinking ahead on post-COVID-19, receiving such capital flows would positively impact on revitalizing the Tokyo FX market, thereby developing Japan’s overall financial markets including capital markets.

Graph 1 in the article shows how Singapore overtook Japan in FX activity in 2008 and HK in 2013. The differences have been widening..

Why Hong Kong will remain an international financial centre, despite new security law

July 7, 2020

Fair bit of articles being written on the ongoing crisis in Hong Kong leading to the island city losing its premium status as an international fin centre.

Horace Yeung (University of Leicester) and Flora Huang (University of Derby) in this piece do not agree with this premise:

While we cannot underestimate some individuals’ fears that they may be arbitrarily detained under the new national security law, there is also evidence that the law will curb the social unrest that has been detrimental to business in Hong Kong. Crucially, our research supports the idea that Hong Kong’s legal system remains stronger than China’s for international business activity. This will ensure it has a competitive edge over China for the time being.

Under Article 8 of the Basic Law of Hong Kong, which serves as the city’s de facto constitution, Hong Kong has a common law system that it inherited from the UK. In this kind of legal system, judges have the ability to make laws in the form of case law, which is determined by rulings on legal precedents. This makes Hong Kong’s legal system much stronger than China’s civil law system, where vast numbers of laws have been written in recent decades but have not necessarily been tried, tested and applied yet.

The ability of judges to make new laws in a common law system means that any issues arising from rapidly evolving financial markets can be dealt with more efficiently. And there is also research showing that common law countries tend to be more responsive to investors’ interests. Hence, in Hong Kong’s new pitch book to the global financial industry, it emphasises the city’s “common law system familiar to international investors”.

Research shows that a robust legal system is of paramount importance to financial development. It makes investors feel more comfortable and thereby expands the size of financial markets.

In our research, we’ve found that Hong Kong’s economic success since the 1997 handover can be attributed to the “one country, two systems” principle. We argue this is due to its common law system and because Hong Kong has been able to maintain an independent set of company and financial laws from the ones in China.


Managing groundwater in India: rationing the commons

July 6, 2020

Nicholas Ryan and Anant Sudarshan in the new NBER WP:

Common resources may be managed with inefficient policies for the sake of equity. We study how rationing the commons shapes the efficiency and equity of resource use, in the context of agricultural groundwater use in Rajasthan, India. We find that rationing binds on input use, such that farmers, despite trivial prices for water extraction, use roughly the socially optimal amount of water on average. The rationing regime is still grossly inefficient, because it misallocates water across farmers, lowering productivity. Pigouvian reform would increase agricultural surplus by 12% of household income, yet fall well short of a Pareto improvement over rationing.


Business in Time of Spanish Influenza: Economic activity declines with and without lockdowns

July 6, 2020

Howard Bodenhorn of Clemson Univ in this NBER paper:

Mandated shutdowns of nonessential businesses during the COVID-19 crisis brought into sharp relief the tradeoff between public health and a healthy economy. This paper documents the short-run effects of shutdowns during the Spanish flu pandemic of 1918, which provides a useful counterpoint to choices made in 2020.

The 1918 closures were shorter and less sweeping, in part because the US was at war and the Wilson administration was unwilling to let public safety jeopardize the war’s prosecution. The result was widespread sickness, which pushed some businesses to shutdown voluntarily; others operated shorthanded.

Using hand-coded, high-frequency data (mostly weekly) this study reports three principal results.

First, retail sales declined during the three waves of the pandemic; manufacturing activity slowed, but by less than retail.

Second, worker absenteeism due to either sickness or fear of contracting the flu reduced output in several key sectors and industries that were not ordered closed by as much as 10 to 20% in weeks of high excess mortality. Output declines were the result of labor-supply rather than demand shocks.

And, third, mandated closures are not associated with increases in the number or aggregate dollar value of business failures, but the number and aggregate dollar value of business failures increased modestly in weeks of high excess mortality.

The results highlight that the tradeoff between mandated closures and economic activity is not the only relevant tradeoff facing public health authorities. Economic activity also declines, sometimes sharply, during periods of unusually high influenza-related illness and excess mortality even absent mandated business closures.


Analysing fiscal conditions of India’s States..

July 6, 2020

Sangita Misra, Kirti Gupta and Pushpa Trivedi in this RBI research paper analyse fiscal conditions of India’s states pre-covid:

Recognising the increasing precedence of fiscal shocks leading to a deterioration in states’ debt due to the realisation of contingent liabilities, this study assesses the debt sustainability of Indian states by employing both conventional debt and augmented debt, obtained by incorporating information on states’ guarantees and their likely fallout on states’ budgets.

The study uses the standard indicator-based approach and an empirical panel data framework for the post-Fiscal Responsibility Legislation (FRL) period 2004-05 to 2017-18. Results indicate that states’ debt is just about sustainable with some potential signs of unsustainability. Guarantees given by states, if invoked, could certainly pose a potential risk to debt sustainability for Indian states.

The clear policy implications that emerge from the paper include the need to revisit and review states’ FRLs with the inclusion of debt as a medium-term anchor, coupled with greater transparency with regard to contingent liabilities/ off-budget borrowings. The paper does not cover the COVID-19 pandemic period and its impact on state finances.

The impact of Covid-19 on State finances is a different story altogether…

Impact of Leverage on Firms’ Investment: Decoding the Indian Experience

July 2, 2020

Avdhesh Kumar Shukla & Tara Shankar Shaw in this new RBI WP:

This paper examined the impact of firm’s leverage on corporate investment in India. The findings of the paper suggested that the high leverage of firms has an adverse impact on their capital expenditure. Also, the relationship between leverage and firm’s investment was found to be non-linear.

Leverage at higher level affects investment decisions much more adversely, particularly for firms with lower investment opportunities. Leverage may affect a firm’s investment behaviour in multiple ways. It constrains firm’s capacity to mobilize external resources for financing new projects. It may discourage shareholders from supporting higher capital expenditure through increased borrowings, as in a scenario of high leverage, major gains from investment may accrue to debtholders (Krznar and Matheson, 2018).

We also find that firms increase their leverage during high economic growth phase, banking on the durability of such high growth. The findings of the paper suggest that the initiatives to clean up balance sheets of banks and deleveraging by non-financial corporates should help in the revival of investment cycle.


Why were married women twice as likely to contract the Spanish Flu in 1918 as married men? Evidence from Malta

July 1, 2020

Historical evidence coming from across the world. Central Bank of Malta held a public lecture by Dr Mario Saliba on the impact of Spanish Flu in Maltese islands:

Why were married women twice as likely to contract the Spanish Flu in 1918 as married men? The answer to this question is one of many fascinating insights to be provided by Mario Saliba during a virtual public lecture.

In an academic paper that Dr Saliba published in 2018 with two Canadian anthropologists, the answer came down to the larger family size a century ago, which put women in constant contact with their children – who were found to carry the Spanish Flu virus for longer periods of time and also shed larger amounts of the virus, among other factors.

The Spanish Flu wreaked unprecedented havoc and killed over 40 million people around the world – more than the number that were killed during World War I.

Malta and Gozo were also affected, with three waves hitting the islands over a period of nine months. Dr Saliba’s research showed that 5.62% of the population in Malta and 9.41% of that in Gozo contracted the disease, according to the notification of infectious diseases. Around 16,000 cases were reported over the 12-month period, but the influenza probably effected some 50,000 persons. The death toll reached 1,000, one in ten of which were recorded in Gozo.

The lecture is here. The paper on which the lecture is based is here.

Prison Labor: The Price of Prisons and the Lasting Effects of Incarceration

July 1, 2020

Belinda Archibong (Barnard College) and Nonso Obikili (Stellenbosch University) in this paper:

Institutions of justice, like prisons, can be used to serve economic and other extra- judicial interests, with lasting deleterious effects. We study the effects on incarceration when prisoners are used primarily as a source of labor using evidence from British colonial Nigeria. We digitized sixty-five years of archival records on prisons from 1920 to 1995 and provide new estimates on the value of prison labor and the effects of labor demand shocks on incarceration. We find that prison labor was economically valuable to the colonial regime, making up a significant share of colonial public works expendi- ture. Positive economic shocks increased incarceration rates over the colonial period. This result is reversed in the postcolonial period, where prison labor is not a notable feature of state public finance. We document a significant reduction in contemporary trust in legal institutions, like police, in areas with high historic exposure to colonial imprisonment. The resulting reduction in trust is specific to legal institutions today.

sixty-five years of archival records on prisons from 1920 to 1995!

Why didn’t Gandhi pay much attention to Spanish Flu?

June 29, 2020

There is little doubt that Spanish Flu for all its severity has missed most history books. The Flu occurred during the momentous period of WWI and added to the ongoing tragedy in world history in terms of lost lives and tarnished families. Yet, it barely features in historical discussions.

Thomas Weber of La Trobe University and Dennis Dalton of Barnard College add to this discussion in this interesting EPW paper. They look at Mahatma Gandhi’s letters during the period to figure what was he thinking and writing during the pandemic. Despite his own family getting infected, Gandhi paid very little attention to pandemic:

When David Arnold urged historians in his 2018 paper to study the 1918 flu pandemic, he could not have known that only two years later his admonition would prove so relevant to the COVID-19 catastrophe. Suddenly the media features lessons to be learned from this “forgotten” scourge of 1918 (Kolata 2020). Is there anything that can be learned from Gandhi’s less than expected ­involvement with the Spanish flu either about him personally or about his position of leadership in the nationalist movement?

As we have shown, Gandhi left the pandemic unmentioned in his public discourse at the time as well as in his Autobiography a decade later. Yet Gandhi, who was dealing with his own illness, was not alone among India’s foremost political leaders in this respect. Jawaharlal Nehru began his political career in 1916. When he recalled that crucial period ­after the war ended, he failed to note the 1918 pandemic in either his autobiography Toward Freedom (1958) or later in Discovery of India (1967).5 The omission in the latter is particularly curious. Nehru did present this moment in graphic detail by relating first the ­economic and psychological deprivation that India endured as a result of British imperialism. He pointedly includes the suffering among all strata of society, “the quagmire and defeatism” directly caused by colonialism. Then, this enigmatic comment:

And this process had eaten its way deep into the body and soul of India, poisoning every aspect of our corporate life, like that fell disease which consumes the tissues of the lungs and kills slowly but inevitably. Sometimes we thought that some swifter and more obvious process, resembling cholera or the bubonic plague, would have been better; but that was a passing thought… And then Gandhi came. (1967: 379)

A puzzling paradox—not only does Nehru miss reinforcing his case against the raj by referencing here the 1918 pandemic, but he implicitly wishes that the flu epidemic had happened without ­remembering that it did. The amnesia is total. And another irony worth noting is that like Nehru, Gandhi never associated the 1918 pandemic with the cost
of ­colonialism.

Where does this leave us? Regardless of Spinney’s assertions, it was not influenza but dysentery, exhaustion, what has been termed a “nervous breakdown,” and surgery for piles that took Gandhi’s mind off matters that would usually have been of fundamental importance to him, especially given that it had laid ashram members low and even lead to the death of close relatives. He more or less ignored the epidemic that was raging around him as Nehru, the British ­authorities in India, and historians of the Raj had done, but perhaps with more reason for doing so.


What are tech clusters and how do they function?

June 29, 2020

William R. Kerr and Frédéric Robert-Nicoud in this NBER paper:

Tech clusters like Silicon Valley play a central role for modern innovation, business competitiveness, and economic performance. This paper reviews what constitutes a tech cluster, how they function internally, and the degree to which policy makers can purposefully foster them.

We describe the growing influence of advanced technologies for businesses outside of traditional tech fields, the strains and backlash that tech clusters are experiencing, and emerging research questions for theory and empirical work.


Designing a CBDC for universal access

June 29, 2020

Bank of Canada researchers – John Miedema, Cyrus Minwalla, Martine Warren, Dinesh Shah – in this staff note lay conditions for a universal access for CBDC.

They speak about the need to store CBDC in a dedicated universal access device (UAD):

  • A CBDC should be as accessible as cash. A CBDC is a digital product that can be designed to include many of the attributes of cash (e.g., ease of use, portability, offline function). Using a CBDC should be a positive and inclusive experience—from acquiring it, to using it in transactions, to being assisted by its support services.
  • Multiple formats for a CBDC can embody the design principles of universal access. The Bank is exploring multiple formats for a CBDC, including conventional online and mobile technologies, as well as custom devices and deviceless solutions. We will consult widely with stakeholders and users on these options.
  • A CBDC could be used through a dedicated universal access device (UAD). One potential concept the Bank is investigating is a custom device that is engineered for universal access while securely storing and transferring a CBDC. The device could incorporate attributes of cash and take advantage of specialized technologies. Such a device should be manufactured at a low cost and issued by the Bank to ensure maximum inclusion.
  • A UAD could be resilient in ways that a smartphone is not. A UAD could embed a local, secure store of value, be network-independent and operate for long periods on a local power source. If there is an infrastructure failure, a UAD may prevent the interruption of digital transactions.

UAD could resemble a pager kind of device. Central Banks could also be looking to set up a wireless company where these transactions could be facilitated.

Interesting to see how researchers are thinking through a merger of benefits of physical cash and today’s technologies while designing a CBDC.

The Role of ICT in the Evolution of U.S. and European Productivity Growth (1977-2015)

June 29, 2020

Robert J. Gordon and Hassan Sayed in this new NBER WP:

We examine the role of the ICT revolution in driving productivity growth behavior for the United States and an aggregate of ten Western European nations (the EU-10) from 1977 to 2015. We find that the standard growth accounting approach is deficient when it separates sources of growth between ICT capital deepening and TFP growth, because much of the effect of the ICT revolution was channeled through spillovers to TFP growth rather than being limited to the capital deepening pathway. Using industry-level data from EU KLEMS, we find that most of the 1995-2005 U.S. productivity growth revival was driven by ICT-intensive industries producing market services and computer hardware.

In contrast the EU-10 experienced a 1995-2005 growth slowdown due to a paucity of ICT investment, a failure to capture the efficiency benefits of ICT, and performance shortfalls in specific industries including ICT production, finance-insurance, retail-wholesale, and agriculture.

After 2005 both the U.S. and the EU-10 suffered a growth slowdown, indicating that the benefits of the ICT revolution were temporary rather than providing a new permanent era of faster productivity growth. This joint transatlantic post-2005 slowdown is consistent with the broader view that ongoing innovation has been less potent in boosting productivity growth compared to earlier decades of the postwar era.


Bank of Korea’s 70th anniversary

June 29, 2020

Bank of Korea was established on 12 June 1950.

The current Central Bank Governor Lee Juyol gave a speech on the anniversary He rightly says this is not the time to self-congratulate:

Today is the 70th anniversary of the Bank of Korea’s establishment. I wish to express my sincere gratitude to our predecessors who devoted themselves to the development of the Bank of Korea and our economy, and to the many people who have supported and encouraged the Bank. I would like to say in addition how much I appreciate the efforts of all members of our staff, who are unwaveringly fulfilling the duties entrusted to them in their positions at a time when our working environment has been dramatically altered by the unprecedented coronavirus pandemic.

Looking back, the Bank of Korea has faithfully carried out its role as a central bank since its foundation in 1950, while making all-out efforts to meet the demands of the times. In the initial stage of economic development, our Bank spared no support as Korea achieved high-speed industrialization-led growth that was the wonder of the world. After experiencing high rates of inflation due to two oil shocks, our Bank devoted its attention to establishing a foundation for price stability. Since the global financial crisis, we have actively carried out our financial stability mandate. All of these efforts have not only provided stepping stones for economic development and stability, but have also laid a foundation for our standing as a central bank to be firmly established.

Commemorating our anniversary today, I see no lack of achievements to celebrate from the past 70 years. But as our economy experiences severe hardship due to the COVID-19 pandemic, now is not the time to congratulate ourselves.


Riksbank giving opportunity to redeem banknotes which became invalid during changeover in 2015-17

June 26, 2020

Riksbank announced a changeover from old banknotes to new banknotes in the period 2015-17.

92% of the notes came back and 8% (worth SEK 5.5 billion) did not come back to the central bank. The central bank allows to convert old notes to new notes for a fee. This fee will be doubled from Oct-2020 onwards:

During the banknote changeover 2015–2017, banknotes worth a total of SEK 88 billion became invalid. 92 per cent of these have returned to the Riksbank, but there are still banknotes missing, amounting to a total value of SEK 5.5 billion. You could buy 10 tonnes of gold for this amount, around 830 bars of gold. If all of the banknotes were laid out in a row next to one another they would stretch as far as 175 marathon races, or 7,400 kilometres.

There is always a possibility to redeem invalid banknotes at the Riksbank. However, for invalid banknotes sent in after 1 October the administration fee will be raised from the current SEK 100 to SEK 200 per case. In recent years, the Riksbank has redeemed 99 per cent of the cases sent in. Further information on how to redeem invalid banknotes can be found on our website.

On 1 October the regulations for redeeming invalid banknotes will also be changed so that only the person who owned the banknotes when they became invalid, or estates of deceased persons, will have the right to redeem the notes. This change means that invalid banknotes that have been sold, gifted, or donated to charity can no longer be redeemed.


The covid pandemic ought to shake up the field of economics

June 26, 2020

Kaushik Basu in this Project Syndicate piece (republished in Mint) writes on the need for change in field of economics. He says the crisis has exposed the notion of central role of markets in efficient functioning of the economy

…..a disruption such as the one caused by covid-19 reminds us how much we take for granted. I realized this during the nearly three months I spent in Mumbai during the lockdown, when family and friends told me of conflicts, showdowns and frayed nerves in the city.

Whereas some residents were castigated for not wearing face masks or for violating social-distancing norms, others were criticized for overdoing the lockdown. Some residents’ associations photographed anyone who stepped out of their home, even if they were alone and far away from anyone else, arguing that such behaviour was irresponsible. Because the behavioural requirements brought about by the pandemic are novel and have yet to stabilize, we are more aware of them than we are of longer-established social norms.

Markets also rely on such norms, most of which, having evolved over time and become routine, lie beyond economists’ explicit assumptions. As Karl Polanyi, Mark Granovetter, and others have argued, the economy cannot be understood as though it stands apart from society. Certain social and institutional preconditions must be present for an economy to function effectively. But the economics profession widely overlooked these important reminders, or, at best, put them aside with a nod.

In my book Beyond the Invisible Hand, I argued that trade and exchange depend not only on technical assumptions of which all economists are aware, such as the law of diminishing marginal utility, but also on other conditions that we take for granted. These include being able to trust one another and our ability to communicate, which allows us to negotiate and conclude deals. But no economist writes down “can talk” as an assumption. It is regarded as a given.

So many such pieces were written post-2008 crisis as well. But little changed. Will the current crisis lead to the changes?

Tracking impact of central banks policies on market fear as implied by options prices

June 26, 2020

Miguel Ampudia, Ursel Baumann and Fabio Fornari of ECB look at option prices to track impact of central bank policies on market fear . The policies have helped curb

An indicator of investor risk preferences or risk aversion can be derived by comparing the risk-neutral density with an estimate of the physical density of equity returns. The risk-neutral and the physical densities are related to each other through the pricing kernel, which embeds investors’ risk preferences. The physical density represents investors’ best judgement about probabilities of future price developments. Expectations of physical densities cannot be determined from market prices, as market prices also embed the risk preferences of investors. Researchers have turned to statistical methods to estimate such densities.[5] We use a daily multivariate generalised autoregressive conditional heteroscedasticity (GARCH) model to achieve this.[6]

The tail risk aversion indicator is constructed by comparing the left tails of the risk-neutral and physical distributions. Investors are risk-averse if they attach a higher risk-neutral probability to adverse events compared with the physical density. As tail risk-averse investors are willing to pay a premium to insure against the disutility associated with adverse outcomes, risk-neutral probabilities will overstate the corresponding physical probabilities for negative tail events. We look at the behaviour of the left tails of both the risk-neutral and the physical densities for equity returns over a three-month horizon. The index of aversion to negative tail risk of investors is calculated as the area to the left of the point on the risk-neutral density that corresponds to the lowest tenth percentile of the physical distribution of the returns (normalised by 0.1, i.e. the corresponding area on the physical density).[7] A tail risk aversion index above one indicates that investors fear the materialisation of negative tail events and are therefore willing to insure against such an occurrence by paying more than would be justified by its historical likelihood.[8] By contrast, an index value between zero and one could be considered as consistent with a situation in which appetite for risk is high.

Chart C

Euro Stoxx 50 tail risk aversion indicator and tail risk

For options with a horizon of 10 to 20 days ahead


Sources: Authors’ calculations and Refinitiv.
Notes: “APP” stands for asset purchase programme and “APP extension” refers to the ECB measures announced on 12 March 2020, “PEPP” stands for the pandemic emergency purchase programme announced on 18 March 2020, “QE” stands for quantitative easing and “VaR” stands for value at risk (tenth percentile). The latest observations are for 13 April 2020.

The estimated tail risk aversion increased measurably from the second half of February. In mid-March, coinciding with the introduction of policy measures on both sides of the Atlantic, it reversed its course and returned to early-February levels. Chart C depicts the estimated tail risk indicator, along with a measure of tail risk, defined as the (inverted) tenth percentile of the physical distribution of the Euro Stoxx 50 returns. Initially, as the coronavirus was largely contained to certain regions in China, markets appear to have been rather complacent in the sense that there was practically no increase in tail risk aversion. At the outbreak of the pandemic in Europe, however, investors’ willingness to take on risk declined measurably, as reflected in the increase in the tail risk aversion index as of 21 February – the start of the lockdown in some parts of the Italian region of Lombardy. Around mid-March, the price of left tail risk started to decline again, as a cascade of fiscal and monetary policy measures was announced on both sides of the Atlantic. By contrast, tail risk itself remained broadly stable until the beginning of March, started to rise significantly thereafter and remained elevated even after the introduction of policy stimulus. One interpretation of these developments is that the measures put into place by central banks and governments have been able to support investors’ risk appetite, thus curbing the initial rise in the price of risk and leading it back to the value prevailing around mid-February. This reduction in the price of risk took place despite the rise in the amount of risk and therefore contributed significantly to minimising the impact of the shock on financial markets.

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