Saturday, February 7, 2009

An Efficient Market?

Paul de Grauwe rightly points out that the market for European sovereign debt has gone nuts. So much for the efficient markets hypothesis. Interestingly, there seems to be a "racial" component to the bias (blond bonds carry lower risk premia):

It is difficult to understand, however, why the market (and the rating agencies) forecast a default of the Spanish government debt, while they do not forecast trouble for the UK, which has a debt build up similar to Spain’s and a more serious banking problem.


Unknown said...

Well, as Président Pompidou once famously said: "quand les bornes sont dépassées, il n'y a plus de limites!".

I think that de Grauwe is right with his view that a substantial part of these movements are pure panick. However, there is an important factor that he doesn't seem to mention, namely liquidity. Being an academic, de Grauwe does not really know what moves markets day to day and he sticks to the pure academic view. This view needs complementing (not substituting) with a view of market dynamics such as liquidity.

In an environment such as the one we have been going through, where trading was for all purposes halted on several markets (remember for instance the interbank market spreads going through the roof), where investors have experienced substantial capital losses, face major redemptions and are coming out of a period of chasing yields anywhere, I am not so surprised that they are trying to get out of relatively small and less liquid markets: the liquidity premium has dramatically increased in the current environment. I think that's an important reason why US, German and French debt remain sought after: you know that you can sell easily anytime. Conversely, should you hold Irish debt and need to sell suddenly a large chunk, you are not sure that the market could absorb it so easily.

Adding liquidity to the risk of default, you get rid of most of the racial bias. Racism does not exist in the market because the market does not experience conscious thought: it is animal!

Leo said...

I certainly lack Bernard's skills, but looking at where blond Celtic Irish stands, it is up there close to Greece which does support his contention that this has nothing to do with hair color.

I take however strong issue with his first sentence. Even though Pompidou did utter this famous sentence, he was quoting le Sapeur Camember.

Rendons à César ce qui est à César (c'est à dire Christophe).

Unknown said...

True, the Irish upset the racial theory of risk. But we can just throw an additional variable into the regression to make it come out OK :)

Unknown said...

The distinction between default and liquidity risk is in itself somewhat "academic," isn't it? Liquidity premia were small enough in normal times to keep spreads betwen larger and smaller sovereign debt markets within limits. The "shunned" markets have become illiquid because buyers have fled them for markets where the default risk is perceived to be lower. If the prospect of default weren't spooking buyers, there would be enough to reduce these remarkable spreads.

Unknown said...


how could I forget ? Abject apologies to the sapeur !


I would disagree. Liquidity and default are two very different things. I am not talking about liquidity as in liquidity crisis. What I mean is market liquidity. Say you are the proud owner of 2 bn celtic bonds in your portfolio and your client wants to redeem his money. Can you sell your 2 bn celtics without upsetting the market. It's got nothing to do with default risk. It's just that the market is not wide enough. I believe that these days, investors put a big premia on market liquidity whereas in past days, when nothing could go wrong, the liquidity premium was much smaller. As a matter of fact, I'd probably be a buyer of Celtics at this time.

Unknown said...

Yes, I know what kind of liquidity you're talking about. You emphasize the smallness of the market and hence the likelihood that liquidating a substantial position will depress prices. I stress rather the illiquidity that stems from an absence of interest on the part of buyers, which can happen even when the market is large. Indeed, one of the original reasons for the popularity of credit default swaps was the illiquid market for many corporate bonds. CDS made it possible to gain exposure to the bonds without actually buying them. If there is a shortage of buyers and no way to hedge one's position, you're stuck if you need to raise cash.

Anonymous said...

Ironically, one of Ireland's problems is that it's pre-crisis debt was "too" low (net public debt of 15%), rendering the market for its debt illiquid in Bernard's sense.

Unknown said...


my point exactly. Say you were a hedge fund looking for a 30bp pickup in August 08, that didn't seem justified by the fundamentals. The trade doesn't look too good now plus you can't sell.