Model Insights - The absence of equity diversification in times of stress
Last updated 19th March 2009 - Read this Insights article authored by John Hibbert
Today 's evolving global capital regimes require firms to assess the quantity of capital required to survive extreme events. Given the rarity of these events, defining 'stress' scenarios for this purpose turns out to be an inherently very difficult task. The year of 2008 has provided a severe test for financial firms which a number have failed to survive.
For firms that bear risk across a portfolio of equity assets a key lesson is that diversification is absent when markets suffer common global shocks. Dependence between equity markets is strongest during periods of stress. Tellingly, the tools to capture this fundamental feature of equity market behaviour already exist. The challenge for firms and regulators is now to acknowledge the compelling case for this class of models. This recognition of economic reality will have a capital cost.