Contagion Down Since December LTRO: Risk Expert

Cross-asset contagion has decreased considerably since the ECB launched its three-year refinancing operation in December, Sebastian Ceria, CEO of Axioma, a portfolio optimization and risk management firm, told CNBC.

Chart for story.jpg

“What we see after the last LTRO is that correlation has come down significantly in a hurry,” Ceria said. “Contagion has been going away, assets are behaving more normally and as a result of that correlations are down to historical lows.”

Ceria explained that asset correlation is typically very high in the aftermath of a market-moving event, only to retreat substantially once investors have had the opportunity to properly assess their risk exposure, and can be thought of as a measure of fear in the market.

“Correlation has been the big story of 2011. Essentially when something happens in the market, people are trying to sort out how an event affects stocks or other assets. Everything moves in tandem,” Ceria said.

“Correlation becomes very, very high. Then, while the market is trying to sort out which are the effects of this particular crisis, then correlation should come down.”

Portfolio managers and investors need more sophisticated risk models in order to evaluate their exposure effectively, according to Ceria.

“The problem these days is that the world is so inter-connected that it’s hard to tell ahead of time what your exposure is if you’re not using sophisticated tools,” Ceria explained.

“The key to modern portfolio management is to really figure out how much of your risk is coming from unintended bets. It’s all about managing those unintended risks, hedging them out so that you can concentrate on the risks that you intend to take,” he added.