“It’s like looking for a freak flood in Brisbane,” said Dr Nagaratnam (Sree) Jeyasreedharan, a lecturer in finance at the Tasmanian School of Business and Economics.
“We can model for 10 or 50 years, but what happens when there’s a one-in-100-year storm?”
The best example of the kind of ‘storm' Dr Jeyasreedharan is talking about is the Global Financial Crisis (GFC) of 2007 and 2008 – the devastating market crash that caught even the most savvy economists and financial analysts off-guard.
These one-off freak things are becoming more and more common, we can’t just brush them under the carpet. We have to take them into account.
Battle of the beta
Traditional asset pricing models predict the rate of return of an asset. They consider the flow of the market as continuous, and use a single ‘beta’ as a measurement of how volatile an investment can be.
Nowadays, a growing number of researchers are calling for financial institutions to adopt a multi-dimensional model to more accurately forecast the ebbs and flows of the market.
“Risk perception in the market is changing every month. So we took the standard beta and varied it over time,” Dr Jeyasreedharan said.
“The next step in capturing the regular and irregular shocks was to split the beta in two: the continuous (or ‘diffusion’) beta, and the discontinuous (or ‘jump’) beta. It’s allowing us to measure the sensitivity of each stock compared to market behaviour."
In academia, such two-dimensional measures are increasingly being used to model discontinuous behaviour in asset pricing, because jumps can better describe the anomalies that arrive at random intervals and disrupt the continuous movement of the market.
Perhaps the most famous jumps of all were the ones that triggered the GFC, revealing to the world that the US housing market was nowhere near as stable as it appeared to be.
“The jump beta drove the GFC – it was a big surprise that shook the market, and the single beta model didn’t factor that in properly,” Dr Jeyasreedharan said.
I strongly believe a dual beta model would address these things. It’s a next-level way of looking at the assets and risks involved. We have to look at them in these two dimensions.
Bridging the gap
Dr Jeyasreedharan’s research is now focussed on making dual beta asset pricing a smarter option for financial analysts in the commercial sector. The ultimate goal is to make the risks of the market clearer to anyone in the investment business.
In other words, Dr Jeyasreedharan wants to help investors “go in with their eyes open”.
“Hedge funds and investment firms are still using the single beta as the norm. Our next challenge is to get the dual beta model accepted. It’s already out there, so we’re trying to bridge the gap between academics and practitioners,” Dr Jeyasreedharan said.
“We need to understand how these prices will change – when the market sneezes, which stock will catch the flu? It’s a two-dimensional picture of risk, which is closer to reality than the original model.”
Dr Jeyasreedharan is also leading a project to better understand how local markets change during times of peace and conflict – and on the flip-side of that, to see if market changes can be used to signal the transition between the two.
“My cultural roots are in Sri Lanka, and there’s not enough information on what it means for the stock market when you go through 30 years of conflict. I wanted to contribute,” he said.
Sri Lanka is a young market – the conflict has only ended in the last five to eight years. It’s like a natural lab for conflict/post-conflict data, where we can apply the same tools we use under normal conditions to see the difference in the behaviour of diffusion and jumps.
What will emerge from his insights – and those of other researchers looking into the Sri Lankan market – is the first ever study comparing various types of models. This will provide local decision-makers with a better understanding of market pressures in times of peace and conflict.
“My long-term intention is to collate a number of academic papers on the Sri Lankan stock market into a book,” said Dr Jeyasreedharan.
“I want there to be one place where all articles on investment behaviour under conflict situations can be accessed and referenced.”