Financial models and the corona crisis
Applying financial models in times of crisis
Models are simplifications of reality which we as humans build to support us in our decision making on complex matters. Models offer no crystal ball, they support us in making decisions but do not make the decisions for us. Models are containers of knowledge and by working with them, we are exploiting this knowledge to the best of our ability in a consistent, objective, transparent and efficient way.
With the help of models we can quantify, analyze and compare the potential consequences of various decisions under different sets of assumptions. In doing so we learn, in a structured way, which decisions work well and which decisions might not. At the same time we have to be aware that models have limitations. By continuously striving to do better, we learn and expand the knowledge that our models contain and thereby improve the quality of the decisions they support.
Prime Minister Scott Morrison of Australia explains measures to control the outbreak of COVID-19 in front of a graph with model-based scenario simulations of how COVID-19 spreads over time depending on alternative policy measures.
And of course, models should always be applied in a sensible way, especially during times of crisis. As such, our experts are on hand to guide you in implementing some practical financial modelling guidelines. Herewith a few examples:
- Combine different scenario approaches to “diversify” across the strengths and weaknesses of various approaches. For example combine a probabilistic model-based approach with deterministic scenarios that are constructed by hand, based on narratives.
- Zoom in on or develop specific adverse (stress) scenarios to create a better risk awareness and to stress-test strategies on their robustness.
- Avoid behavioral pitfalls, for example changing input assumptions to obtain desirable outputs.
- Perform sensitivity analysis on model parameters which are especially important for proposed strategies.
How recent market developments compare to our scenario models
Based on our experience in building and applying scenario models, and the knowledge gleaned from previous crises, our scenario models have features which are particularly important in the current environment. These scenario features are designed to reflect, as best possible, how economic variables and asset returns behave in reality. Below are a few of these features:
- Returns follow skewed and fat-tailed distributions, and are not based on Normal distributions.
- Volatilities and correlations between assets increase in times of crisis.
- Scenarios are based on very long term historical datasets (dating back to 1900) covering a wide range of financial market circumstances and economic regimes.
- By complementing our scenario models with forward looking views and expert opinion our scenarios are based on more than historical data alone.
We have compared our previous scenario outlooks of asset returns, yields and exchange rates with the recent financial market developments based on a typical portfolio.
We have found that the recent short-term market developments are (of course) very extreme. Short-term returns of a representative portfolio have materialized in the worst 1% of the probability distribution. The results also show that returns that we are experiencing are in similar ranges as those witnessed during the Global Financial Crisis. This perspective is particularly relevant for clients that have to decide on the rebalancing of their portfolio.
But from a medium-term perspective the recent market developments are far less extreme: the value of the representative portfolio has materialized in the central 50% of the projected probability distribution, 3-years ago. This perspective is particularly relevant for clients that use our models to support their investment decision making for medium to long-term horizons.
Implications of the corona crisis for our scenarios
Looking forward, the corona crisis will have a material impact on our scenario risk and return outlook. We expect that our models will point to a worsening of the outlook on medium-term horizons as the latest data per the end of March is incorporated. The driving force for these changes will be a worsening of the global business cycle and its outlook.
We also expect that expert external views will be needed and imposed that lead to a further worsening of the outlook. These views will reflect the “exogenous” and severe impact of COVID-19 on global economic activity, expected returns and volatility on financial markets. Some of these effects may be partly balanced by the strong monetary policy and government support measures. It is clear that the corona crisis has brought an abrupt end to the 10-year bull market. A global economic recession now seems inevitable, materializing via the downside risks to the business cycle.
Finally, during these challenging times, objectivity and a robust and structured use of data, the knowledge contained in models as well as experienced individuals that understand your challenges, are essential when attempting to make the most appropriate investment decisions. We, the people of Ortec Finance, and our models, are as always at your service.
Please also download our whitepaper on "Financial models and the corona crisis"