Risk-On Risk-Off: Its effect on the Australian stock

market

TARIQ HAQUE

University of Adelaide 2

What is Risk-On Risk-Off?• Risk-On: When many investors are less risk-averse

and buy risky assets such as equities and sell off safe assets such as bonds

• Risk-Off: When many investors are more risk-averse and sell risky assets such as equities and buy safe assets such as bonds

• A global and recent phenomenon– Events that have caused Risk-Off:

• Ben Bernanke warning on US subprime crisis (July 2007)• Collapse of Lehman Brothers (September 2008)• Downgrading of US Sovereign debt (August 2011)• Ben Bernanke announcing a wind-down of QE (June 2013)

– Events that have caused Risk-On:• Ben Bernanke announcing QE 1, 2,and 3• Draghi Put speech (July 2012)

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Implications of Risk-On Risk-Off• Intra-stock and intra-bond correlations more

positively correlated– Correlations between stocks and bonds become more

negatively correlated

• Greater volatility in returns to an asset class • Greater importance of sector allocation within an

asset class compared to security selection• Importance of Factor timing• Effect on carry trades and Long/short strategies

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Focus of this study

• What effect does Risk-On Risk-Off have on the Australian stock market?

• How do we classify a Risk-Off or Risk-On market?

• This is an important question as RORO often coincides with financial crises and there is a lot of capital invested in equities (due to super)

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Data

• Sample period: April 2002 – April 2013

• Weekly returns to 10-year government bonds: US, UK. Japan, Australian, European Monetary Union

• Weekly returns to equity indices: S&P 500, Russell200, FTSE 100, Nikkei 225, Eurostoxx 50, Dax 30, ASX200

• Rolling correlation technique using a rolling window of 52 weeks

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Changes in correlation over time

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Risk-On Risk-Off in our sample

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Average returns(%pa) in RORO vs Non-RORO periods

Non-RORO

RORO Risk-On Risk-Off

ASX200 14.8% 0.5% 86.9% -89.8%

ASX_GOV_BOND 5.7% 7.3% -7.5% 22.8%

GROWTH 14.3% 2.3% 92.9% -92.3%

VALUE 15.8% 2.1% 86.6% -86.3%

LARGE_GROWTH 13.8% 2.4% 91.1% -90.3%

LARGE_VALUE 15.5% 2.1% 86.3% -86%

SMALL_GROWTH 17.8% 2.6% 105.5% -105%

SMALL_VALUE 17.2% 0.0% 88.6% -92.7%

ASX100 17.5% 0.9% 86% -88.1%

ASX_SMALL_ORDS 12.6% -2.8% 99.7% -109.8%

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Average returns(%pa) in RORO vs Non-RORO periods

Non-RORO

RORO Risk-On Risk-Off

CONS_DISCRETION 6.5% -1.7% 67.1% -73.7%

CONS_STAPLES 17.1% 5.7% 46.4% -36.9%

ENERGY 27.7% -4% 100.8% -113.4%

FINANCIALS 14.5% 2.4% 89.5% -88.6%

HEALTHCARE 17.9% 4.4% 38.6% -31.3%

INDUSTRIALS 11.5% -5.2% 77% -91%

IT 15.5% 0.6% 67.5% -69.4%

MATERIALS 19.4% 0.9% 126.5% -130.3%

T’COM_SERVICES 8.5% 8% 31.9% -16.9%

UTILITIES 18% 4.7% 46.2% -38.5%

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Conclusions

• The performance of the Australian stock market is vastly different in normal conditions versus Risk-On Risk-Off conditions

• Risk-On Risk-Off conditions have been in existence from July 2007 – December 2012

• Other important applications:– Foreign exchange , commodities, bonds, property– Asset allocation in superannuation funds– Forecasting Risk-On Risk-Off

• Will Risk-On Risk-Off continue into the future?