Using The Market Dislocation Index to Enhance Portfolio Risk Adjusted Returns

We have seen the dislocation of financial markets at breakneck pace within a plethora of imploding asset values and credit balloons. Markets are operating under extremely stressful conditions and experiencing large, widespread asset mispricing. Significant market dislocations have become not uncommon over the past 20 years. They can provide attractive buying opportunities for those prepared to provide liquidity (at a discount) when sellers demand.

It’s all down to timing and capitalizing on dislocations has the potential to enhance a portfolio’s risk-adjusted returns. In that backdrop and our work with crowd behavior we went back and looked at a paper by Paolo Pasquariello in 2014 at the Ross School of Business, University of Michigan.

Is Financial Market Dislocation Risk Priced?

To be clear much of this is violence is a rebalancing of mispricing on the top side with the rampant bull markets of 2021. We have seen systematic dislocations in global capital markets with multiple bifurcations, from political events such as Brexit, extreme partisan politics in many countries such as the USA, Covid fear and lockdowns, mismanaging of energy transition through populism and more.

The fear politics that gripped the world led to massive equity and wealth shifts. On top of that supply chain breakdowns. Multiple headwinds in the midst of undoubtably some of the ineptest self-righteous politicians and central bankers allowed to operate by irresponsible media and an entitled populations in Western nations. Then throw on top of all this Russia’s throwback to old day Soviet and invading Ukraine that sent natural gas and other commodities to record highs forcing the inept politicians and bankers to act, which has not been clinical or efficient.

Paolo Pasquariello in 2014 at the Ross School of Business, University of Michigan studies market dislocations and developed the MDI.

Financial Market Dislocation Index

Dislocations occur when financial markets, operating under stressful conditions, experience
large, widespread asset mispricings. This study documents systematic dislocations in world
capital markets and the importance of their fluctuations for expected asset returns. Our novel,
model-free measure of these dislocations is a monthly average of hundreds of individual
abnormal absolute violations of three textbook arbitrage parities in stock, foreign exchange,
and money markets. We find that investors demand statistically and economically significant
risk premiums to hold financial assets performing poorly during market dislocations, that is,
when both frictions to the trading activity of speculators and arbitrageurs and their marginal
utility of wealth are likely to be high. (JEL G01, G12)

While we have had many dislocations in recent years, we are keen to look at now. We have seen the biggest fall in multiple bond markets, record falls in currencies and swift collapses of equity markets. Markets globally were pictures of panic, currency markets, commodity markets, stock markets and bond markets all had moments of violence. Global currency and bond markets have dislocated, creating a huge predicament for the global leveraged speculating community that is awash with derivatives without less and less liquidity.

Markets are on edge as governments and central banks collide, we see that in the US with Biden and Powell and in the UK its amplified with the new Truss government’s tax cuts bringing out the bond vigilantes who slaughtered the gilts and at the same time besides soaring rates pounded sterling.

If we look at just the UK, 10-year government bonds (gilts) yields jumped 33 bps Friday, a massive 69 bps for the week to the highest yields since 2010. Ten-year UK “gilt” yields jumped 33 bps Friday and an alarming 69 bps for the week, to the highest yields since 2010. Two-year UK yields spiked 44 bps Friday and 81 bps for the week to 3.93%.

From that GBP, CAD, AUD and NZD all collapsed versus the USD.

Similar moves have happened in commodities, equities and currencies and bonds of other nations. The point is they are violent, fast and the markets are mislocated. Where and how do investors and traders find value in these markets.

These dislocations are becoming more common and are “a major puzzle to classical asset pricing theory” (Fleckenstein, Longstaff, and Lustig 2013). However, what have policy makers learnt, clearly not much!

The turmoil in both U.S. and world capital markets in proximity to the 2008 financial crisis is commonly referred to as a major “dislocation” (e.g., Goldman Sachs 2009; Matvos and Seru 2011). Policy makers either don’t fully understand the source of financial fragility and economic instability or simply don’t care. In the US when you have Federal Reserve bankers trading the stock market and Nancy Pelosi and her husband trading stocks it tells you the answer lies in the latter. The fictional Gordon Gekko has come to life in these times. When greed dictates decision making there should be no surprise what has happened.

It is shameful of where we are at when we look at the recurrence of severe financial market dislocations over the last three decades and what have we learnt to make a safer structured marketplace.

  • Mexico in 1994–1995
  • East Asia in 1997
  • Long-Term Capital Management [LTCM]
  • Russia in 1998
  • Argentina in 2001–2002
  • GFC 2008
  • Covid 2019
  • Everything Bubble 2022
Historical market dislocations

For the purpose of this study we have chosen up to crisis before the COVID and Everything Bubble dislocations given the extreme QE involved for a more objective view (chart above).

Financial market dislocations are elusive to define, and difficult to measure. The assessment of absolute mispricings is subject to considerable debate and significant conceptual and empirical challenges (O’Hara 2008).

The Financial Market Dislocation Index (MDI)

The index is a composite of relative mispricing’s in global stock, foreign exchange, and money markets.

The index captures the commonality in a large cross-section of potential violations of three textbook arbitrage parities in those markets. Hence, it aims to assess the systematic significance of those observable and unobservable, explicit and implicit forces behind their occurrence. Next, we describe each of these parities, the procedure for the construction of our index, and the index’s basic properties.

The composite index MDI m, based on minimal manipulations of observed model-free mispricings in numerous equity, foreign exchange, and money markets, is easy to calculate and displays sensible properties as a measure of financial market dislocation risk.

Regressors include:

  • Monthly U.S. stock returns (from French’s Web site)
  • Official NBER recession dummy,
  • World market returns (from MSCI),
  • Innovations in Pastor and Stambaugh’s (2003) liquidity measure (based on volume-related return reversals, from Pastor’s Web site),
  • Monthly changes in Chauvet and Piger’s (2008) historical U.S. recession probabilities (from Piger’s Web site),
  • VIX (monthly average of daily S&P 500 VIX, from CBOE),
  • World market return volatility (its annualized 36-month rolling standard deviation),
  • U.S. risk-free rate (one-month Treasury-bill rate, from Ibbotson Associates),
  • Slope of U.S. yield curve (average of ten-year minus
  • One-year constant-maturity Treasury yields, from the Board of Governors),
  • U.S. bond yield volatility (annualized average of 22-day rolling standard deviation of five-year constant-maturity Treasury yields, as in Hu, Pan, and Wang 2013),
  • “TED” spread (average of three-month USD LIBOR minus constant maturity Treasury yields, from Datastream),
  • Default spread (average of Baa minus Aaa corporate bond yields, from Moody’s), and innovations in Adrian, Etula,
  • Muir’s (Forthcoming) broker-dealer leverage (from Muir’sWeb site).

Variable selection is driven by the earlier observation that mispricings are more likely during periods of U.S. and/or global economic and financial uncertainty, illiquidity, and overall financial distress.

What is clear investors in foreign currencies, commodities and emerging markets require a meaningful compensation for exposure to such risk implying a dislocation premium. This also applies to the beta rating on equities and bonds.

Financial Market Dislocations Conclusions
Dislocations occur when financial markets experience abnormal and widespread asset mispricings as we have seen in 2022. This study argues that dislocations are a recurrent, systematic feature of financial markets, one with important implications for asset pricing.

The study measured financial market dislocations as the monthly average of innovations in hundreds of observed violations of three textbook arbitrage parities in global stock, foreign exchange, and money markets. Their novel, model-free market dislocation index (MDI) has sensible properties, for example, rising in proximity of U.S. recessions and well-known episodes of financial turmoil over the past four decades, in correspondence with greater fundamental uncertainty, illiquidity, and financial instability, but also in tranquil periods.

Financial market dislocations indicate the presence of forces impeding the trading activity of speculators and arbitrageurs. The literature conjectures these forces to affect equilibrium asset prices. Accordingly, they found that investors demand significant risk premiums to hold stock and currency portfolios performing poorly during financial market dislocations, even after controlling for exposures to market returns and such popular traded factors as size, book-to-market, momentum, and liquidity. This evidence provides further validation of their index.

Their analysis contributes original insights to the understanding of the process of price formation in financial markets in the presence of frictions. It also proposes an original and easy-to-compute macroprudential policy tool for overseeing the integrity of financial markets and for detecting systemic risks to markets’ orderly functioning.

Source: Researchgate Pimco