Market behaviour

The recent stock market drops and increases in volatility have left many investors wondering about future prospects and expected returns. In this article, we analyse the recent macro-economic changes in light of the Capital Asset Pricing Model.

Interest rates, the Efficient Frontier and Leverage

According to the Capital Asset Pricing Model, the market portfolio offers the best achievable risk-return ratio as shown in Figure 1. With the past all-time low interest rates, the market portfolio was giving a decent return at a lower risk than what investors are used to in general. If we assume that investments are mainly based on risk, the market portfolio was below the risk threshold the majority of investors are used to. This resulted in investors increasing the returns up to the risk threshold by applying leverage, benefiting from the cheap cost of borrowing. See Figure 2.

However, as we saw recently, interest rates increased worldwide and the financial markets expect even more positive adjustments to counter inflation. Hence, the market portfolio achieving the best risk-return ratio changes accordingly as shown in Figure 3. Professional investors adapt their portfolio in order to get the best risk-return investments, but many transitional factors have to be taken into account.

Firstly, the leverage can not be kept at the same level due to higher costs of borrowing and increased risk. Indeed, the same leverage will yield a risky position, much larger than the investors risk threshold. Therefore, investors decrease the leverage.

Secondly, assuming that a decrease in leverage by investors increases the volatility, it will in turn trigger traders and hedge funds to decrease their leverage due to increased risk. This is exactly what futures markets have been suggesting recently.

Hence, with the extremely volatile markets resulting from all those changes in leverage, one can assume that investors seeking the optimal risk return ratio unwind their position, calculate a new market portfolio, keeping in mind the short term volatility surge, and slightly rebalance their portfolio while the markets recover over time.

Conclusions After having analyzed the current market trends showing a surge in volatility and a drop in leverage, one can expect the recent market drops to be due to a transition between leveraged investments benefiting from low interest rates, and a more risky market portfolio in line with more standard interest rates as seen in the past.