Deutsche: The Market Broke In 2012, “This Is What Everyone Is Talking About”
by Tyler Durden
ZeroHedge.com
Jul 2, 2017
Two weeks after Deutsche Bank’s whimsical, James Joycean derivatives strategist, Aleksandar Kocic disaggregated the market’s current sweeping complacency regime in a florid stream-of-consciousness report, and warning that the market’s current “metastability” would lead to “cataclysmic events”, with a crash becomes increasingly more likely the longer price discovery in the market (one not propped up by Federal Reserve) is delayed, in his latest note from this week he takes on a more practical – if just as abstract – target; quantifying complacency, both in a market sense and as a metaphysical concept (long-term readers of Kocic are all too aware that when it comes to fusing markets and philosophy, mostly of the post-modernist bent, nobody even comes close).
While we offer readers a TL/DR, Cliff Notes recap at the end of this post for those with little patience for parallels between existentialist, information overload and the decay of the VXX, we urge following Kocic’ narrative, if for no other reason than to comprehend to what abstract levels of market intellectualization the current phase of market “breakage” – courtesy of central banks of course – has prompted such otherwise dry commentary as cross-asset derivative analysis.
We start with Kocic’s definition of “complacency”, which the DB explains “carries a negative connotation — there is something narcissistic about it. It implies unhealthy inward-looking perspective: One imagines of being in a better position than he really is, missing an opportunity to improve. When used in the market context complacency implies a state of comfort that is out of sync with perceived levels of risk. It is almost always identified with shortsightedness, a mistake associated with overlooking the long-term consequences. In the same way a boxer who drops his guard runs a risk of being knocked out, complacent markets are facing a potentially painful encounter with reality.”
With this brief detour into the fusion of trading and philosophy out of the way, Kocic then proceeds to do something nobody else has done before: quantify market complacency.
To do that, Kocic notes that at first one has to define the frame of reference of complacency. “Relative to what” should complacency – a conditional category that both reflects the absence of risk aversion and also is synonymous with taking on an unhealthy amount of risk – be quantified?
“In the same way risk aversion requires comparison of two independent measures of risk, complacency is defined relative to a perceived level of (unrealized) risk.”
As frequently happens in finance, Kocic uses a coin toss thought experiment to lay out the problem:
Consider a coin toss as an example. The physical probability between heads and tails is 50/50. However, any bets that involve coin toss as a decision instrument will always overweight probabilities of unfavorable outcomes. For example, if the payout of the gamble is $10 for the heads and $0 for the tails, no one would pay $5 (the expected value = 50% * $10 + 50%* $0) to play, but less than that, say $4. So, the actual price is evaluated as an expected value with 60/40 probability assignment (40%*$10 +60%*$0 = $4). This is the essence of risk aversion. Because the actual risk involved in a coin toss can be accurately determined, reweighting of probabilities which incorporate risk preferences can be measured precisely and quantified. The price of risk aversion is $1, the risk premium that is the difference between the expected price of $5 and the $4 at which it is traded.
The Rest…HERE
