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Safe haven flows in times of crisis

Written by Philip Schubin

Grade 1.0

Paper category

Term Paper


Business Administration>Finance




Term Paper: The reason why the haven is attractive may not be clear at first, but it becomes reasonable after inspection. The main motivation of investors willing to pay high opportunity cost can be explained by the uncertainty of future development they face when the market is down. In the traditional sense, investors seek safe havens as a store of value to maintain or even increase value during market cycles. Foreign investors prefer to buy U.S. securities investment to benefit from the highly developed, liquid and efficient U.S. financial market. Especially if their domestic financial markets have a low correlation with the returns of the U.S. market (Kristin J. Forbes). The possibility of maintaining solvency during a severe recession, maintaining stable cash flow to meet the required output, and the benefits of having additional liquidity to take advantage of the opportunities created by market chaos, continue to attract investors into safe havens (Tushka Maharaj, 2019 year). Now consider that all investors know that with the help of safe assets to diversify their investment portfolios, and a serious incident such as the Covid-19 virus will affect every corner of our world, leading to fundamental consumer buying behavior Variety. Can these safe assets withstand the pressure of market selling and still provide a reliable store of value? Portfolio Theory in the Covid-19 Era Cross-category diversification is an effective goal for portfolio construction. According to modern portfolio theory (MPT), risk-averse investors can optimize their portfolio by adding certain assets and diversifying their investments to reduce volatility. This theory will be tested in 2020. According to the IMF, we will face the worst economic crisis since The Great Lockdown. As all investors are redistributed to safe havens, hoping to minimize the volatility of their portfolios, the situation may be the opposite. Krishnamurthy and Vissing-Jorgensen (2012) provide historical evidence that safe assets are highly price sensitive to supply and demand shocks. Prior to the unexpectedly dysfunctional $18 trillion market in March 2020, U.S. Treasury bond trading was at a high level, and these increases in demand can clearly be seen. The deepest and most liquid market US Treasury bonds are considered the safest and most liquid market in the world. The federal government borrows through the issuance of national debt, and global investors use it as a hedging tool and store of value. These securities, called bills, notes and bonds, are sold through auctions by the Ministry of Finance. In addition, these Treasury bonds are actively traded in the secondary market, with a daily trading volume of approximately US$550 billion (US-daily trading volume). As the pandemic worsened, investors felt that financial markets had been significantly affected, as many people sold Treasury bonds and converted them into cash, either with short-term debt and other position losses as a settlement, or willing to invest in a severe downturn Stock. Due to this large-scale sell-off, the market is unable to cope with the surge in Treasury bond sales, making it difficult to execute medium-scale transactions and increasing transaction costs. Due to post-crisis regulatory requirements after 2008, banks that should have bought and stored assets to cushion problems caused by demand or supply shocks are reluctant to do so. As the sell-off intensifies, banks face balance sheet restrictions and internal risks to limit volatility. The fact that banks are unable to promote matching between buyers and sellers puts others at risk of loss. This fact leads to a cycle of further losses and additional selling. In addition, the price of Treasury bond futures deviates from the underlying bond with which it is related. The breakdown of the close link between these two prices poses a challenge to cash futures basis trading. This strategy is mainly used by a very small number of highly leveraged hedge funds to profit from the price difference between future contracts and Treasury bonds. Although the profitability is usually very small, such as a few cents per 100 dollars, as the price difference increases, these transactions become more attractive to other investors. As a result, larger funds that usually invest funds in credit markets now hold these almost risk-free and almost certain profit positions by giving up other markets and increasing Treasury bond selling. Other small factors, such as traders who work from home, cannot respond at the required speed, or the unexpected and unforeseen damage caused by COVID-19 to our economy, exacerbated this situation. The safety of the safe harbor As the example of American securities shows, the safest assets have felt the pressure of large-scale selling caused by the economic recession. In addition, precious metals such as gold have also experienced a similar sell-off. Compared with the stock market, major cryptocurrencies have a strong procyclicality. Therefore, investors should not rely on a single thing, but should diversify their investment portfolio and constantly assess potential futures risks. After the March 2020 shock, the Fed proposed new regulations to relax bank leverage ratio rules, launched a quantitative easing policy, and significantly expanded repurchase operations. These measures seem to have worked, stabilizing the market again and restoring the previous liquidity and depth. Nonetheless, this still leaves a lot of uncertainty for the future, as record numbers of infections are actually announced every day. Read Less