Recent and continuing events in emerging markets and in the Ukraine have demonstrated clearly how irrationally and emotionally markets, whether equity, FX, bond or credit, can behave in terms of assessing and pricing perceived risk. “Risk On/Risk Off” appears to have returned with a vengeance; while the S&P and other indices scale new heights.
At Awbury, we believe that, while one cannot ignore what the market “thinks” is the appropriate price for a particular risk at any point in time, one has to remain focused and rational and try to avoid being distracted by the noise that often corrupts or obscures what the true risk/reward calculation should be.
Of course, our world of Financial Catastrophe (FinCat) insurance is, by definition, one in which an underwriter has to be very sure that his/her assumptions and risk modeling are robust, rigorous and defensible; and that what is being priced is risk, not uncertainty, as we have commented before.
Rather than obsess over what seems increasingly a misleading distinction between Developed, Emerging and even Frontier markets (which can lead to all sorts of framing issues), one should focus on the true nature of the risk; the context in which it is being underwritten; and the legal and institutional protections that surround it. Which would you rather have: Greek bonds under local law, or under English law? Is Greece a Developed market, or (re-)Emerging?
Thus, to be able to price a risk properly, one must consider it dispassionately and rationally; because, in doing so, one is much more likely to make a decision that is proved correct and avoids loss. To paraphrase Benjamin Graham, in the end the Market is a weighing machine and will find you out.
Of course, the Dark Lord can be your friend, when he prevents you from becoming part of the casualty list of those left exposed by underpriced risk, weak terms, and unenforceable contracts, because the market “thought” it knew better, misunderstood correlations and probabilities, or viewed QE and central bank behaviour as rational (the Eurozone is “an island of stability”) and predictable.
Awbury’s view is that one needs to understand that emotion does have an often-unacknowledged influence in decision-making and that one needs to factor that into one’s underwriting analysis, trying to determine the extent to which it may affect outcomes or events.
-The Awbury Team