Pyramid of Financial Risk

Financial risk, as we all know, always come into the limelight first during time of market stress. In such times, the value of liquidity becomes paramount for investors. Liquidity, which denotes the ease of converting an asset into cash without significant value loss, is especially prized. Investors seek assets with high liquidity as they can be swiftly turned into cash, providing essential flexibility in challenging market conditions.

When economic turmoil hits, certain assets, take U.S. government bonds for example, gain prominence due to their perceived safety. Investors tend to gravitate towards these bonds because of their relative security and the ease with which they can be converted into cash. Understanding the significance of liquidity and recognizing safe-haven assets like U.S. government bonds is crucial for investors to navigate and manage financial risks effectively during periods of market uncertainty.

The Exter’s Financial Pyramid

John Exter, a prominent economist and former Federal Reserve member, introduced this financial risk model back in the mid-1970s, where his inverted pyramid gained widespread recognition. 

*Derivatives represents notional value, the total value of the underlying contract. Unfunded government liabilities are debt obligations that have insufficient funds to pay for them.

**Paper Money represents tangible currency including coins and bank notes. 

***Gold is based on a spot price of $1,750 per oz and 205,238 tonnes. 

Based on his pyramid to the present financial landscape, the illustration highlights derivatives as among the riskiest assets. Derivatives are financial instruments linked to the movements of underlying securities such as currencies or commodities. Notably, they often involve high leverage, enabling investors to make substantial wagers with minimal initial investment. However, this leverage comes with the potential for rapid and significant losses. The stunning notional market value of USD600 trillion derivatives hold highlights the substantial presence and impact of derivatives in today’s financial markets. 

Private businesses and real estate are considered to have higher financial risk due to the lack of a central marketplace, making them less liquid and more challenging to convert into cash quickly. Moving down the pyramid, listed stocks on the stock market present a moderate level of risk as they are traded in a centralized market, disclose financials, and adhere to securities regulations. The US government bonds are viewed as relatively low-risk globally due to its none defaulted history on its debt and also having the greenback’s role as a reserve currency. Short-term Treasury bonds are considered safer than their longer-term counterparts due to a lower chance of default within a shorter holding period. In times of liquidity squeezes, many consider cash money to be a reliable asset. However, according to some perspectives, gold is deemed the safest asset due to its finite supply.

Chain Reaction Across the Pyramid

In times of a market crisis, the assets positioned at the top of the pyramid often experience the most significant drops in value. Conversely, as we move down the pyramid, the degree of loss tends to decrease. During such crises, assets considered relatively safer may even see an increase in value due to heightened demand.

To illustrate this, let’s take a look at the 2020 market crash:

During this period of uncertainty, the value of oil plummeted by over 60%, a common occurrence when the economy is weaker since demand for oil typically decreases. On the flip side, longer-dated bonds saw an increase in price, about 18% jumped as depicted in the table.

It is essential to note that actual returns during crises may not perfectly align with the hierarchical order of the pyramid. However, this model serves as a general guide, offering insights into how various assets might respond during challenging market conditions.

Conclusion

In times of economic turmoil, certain assets gain popularity for their perceived safety as well as liquidity. Investors highly value liquidity in uncertain times because it provides flexibility. Assets that are more liquid can be quickly turned into cash, offering a degree of financial maneuverability.

Understanding the role of liquidity and recognizing safe-haven assets helps investors to navigate and manage financial risks during times of market uncertainty. Although the actual returns during crises may not be truly reflected from the pyramid, it can still serve as guidelines on how certain assets respond across the pyramid.