UOA10-11: Risk On / Risk Off: from academic research to financial market staple
Submitting InstitutionUniversity of Oxford
Unit of AssessmentMathematical Sciences
Summary Impact TypeEconomic
Research Subject Area(s)
Economics: Applied Economics, Econometrics
Commerce, Management, Tourism and Services: Banking, Finance and Investment
Summary of the impact
This case study charts the influence of the Risk On / Risk Off (RORO)
paradigm, developed in research at the University of Oxford in
collaboration with investment bank HSBC. Since 2008, RORO has had a
significant economic impact on HSBC as well as wider impact on the
thinking and actions of investors and other global market participants.
Having begun as a specialised research tool within HSBC's foreign exchange
team, the RORO methodology was publicised in the advice that HSBC supply
to a wide range of major fund managers, corporate institutions and central
banks. The research has led directly to a change in the way that asset
managers think about investment decisions, with consequent impact on the
investment and risk management strategies they undertake. RORO is
regularly featured in the financial press and is becoming increasingly
mainstream, with coverage in national and international media aimed at
The collapse of Lehman Brothers in 2008 precipitated a dramatic and
enduring change in the correlation structure of global financial markets.
This has become widely known by investment professionals as the Risk
On/Risk Off (RORO) phenomenon — a term coined by the authors of the
research considered below, and now common market parlance.
Researchers in the University of Oxford started thinking about the
temporal evolution of multi-asset correlations and their relationship to
macro-economic and geo-political events in 2008. In  these were
characterised and measured using evolving correlation matrices, which were
constructed from a large dataset covering 98 major asset prices over 12
years from January 1999. The research compares the realised correlations
with those that would result from a random-matrix equivalent, revealing
that there is structure in the data that is not present in the Gaussian
model used in standard financial theory. This structure is investigated in
more detail via a Principal Component Analysis. A key result is that
before the collapse of Lehman Brothers in September 2008, the first
component is generally unremarkable and many assets are close to
uncorrelated (see the left-hand panel of the figure below, in which the
colour indicates the strength of correlation). Post-Lehman, a dominant
component emerges, the strength of which is tightly coupled to market
events, as illustrated in the right-hand panel of the figure below, in
which all bonds are closely correlated, as are all equities.
The research  provided a view of the markets which came to be known as
RORO. This is the direct manifestation of the Principal Component Analysis
in , and is backed up by the parallel studies [2,3] which use
techniques from network analysis to develop algorithms to detect large
clusters which may indicate the presence of changes of risk states. RORO
uses two states to characterise market conditions, and individual assets
are characterised as being either risky assets, or safe-havens. "Risk On"
periods see investors buy risky assets and employ traditional
correlation-based strategies, although even in these periods, correlation
levels are much higher than was typical before the financial crisis. Thus,
risky assets rise in value and safe-haven instruments fall. In "Risk Off"
periods these moves swing into reverse as investors all move into safe
havens, which all become highly correlated. RORO has profound consequences
for asset managers as well as for other market participants such as hedge
funds, corporate institutions and central banks.
A second significant outcome of the research, also described in , was
the development of PCA- based graphical and quantitative methods to
analyse the evolution of correlation structure, track the RORO phenomenon
and monitor its influence on particular assets.
The underpinning research was carried out at the University of Oxford
between 2008 and 2011 together with colleagues from HSBC. The key
researchers were Mason Porter (University Lecturer, 2007 to date) and Dr
Nick Jones (Research Fellow, 2008-2012).
References to the research
*  Fenn DJ, Porter MA, Williams S, McDonald M, Johnson NF & Jones
NS. Temporal evolution of financial-market correlations. Phys.
Rev. E 84, 026109, 2011. DOI 10.1103/PhysRevE.84.026109.
*  Fenn DJ, Porter MA, McDonald M, Williams S, Johnson NF, & Jones
NS. Dynamic Communities in Multichannel Data: An Application to the
Foreign Exchange Market During the 2007-2008 Credit Crisis, Chaos, 19,
033119, 2009. DOI 10.1063/1.3184538.
*  Fenn DJ, Porter MA, Mucha PJ, McDonald M, Williams S, Johnson, NF,
& Jones NS, Dynamical Clustering of Exchange Rates,
Quantitative Finance, 12, 1493-1520. 2012. DOI
The three asterisked outputs best indicate the quality of the
underpinning research. All these papers are in high quality
internationally refereed journals.
Details of the impact
The primary impact of the research described in Section 2 is economic,
and the beneficiaries are HSBC and other financial institutions. There is
secondary societal impact in the adoption of RORO as a standard term in
media coverage of financial markets. All impacts have occurred since 2008.
From research to impact
The HSBC Foreign Exchange Group were key partners in the development of
the underpinning research, three HSBC employees were coauthors, and HSBC
coined the phrase RORO. The underpinning research was taken up by the
Foreign Exchange Research Group at HSBC, the world's third largest bank by
market capitalisation. The bank has a major presence in global markets
with large trading operations in all significant asset classes. Trading is
undertaken on behalf of clients, including institutional and sovereign
fund managers, central banks, charities, and supra-national organisations.
HSBC Research actively engages with its client base, both enhancing the
clients' background understanding of markets and providing advice on
specific investment and trading strategies.
The Head of FX Quantitative Strategy at HSBC states [A] "The RORO
research was translated from the original PRE paper into two major HSBC
Global Research publications [Risk On-Risk Off: a paradigm is born
(2010) and Risk On-Risk Off: Fixing a broken investment process (2012)],
aimed at Market Practitioners". These publications explore the
far-reaching consequences of RORO for market participants, and describe
techniques explicitly devised to combat the phenomenon, with strategies to
aid market participants in incorporating this new view of the market into
their planning. HSBC also devised the HSBC RORO Index (illustrated below)
to quantify the RORO effect.
Nature and extent of the impact
Investors have traditionally relied on certain guiding principles, some
of which are consistent with standard finance theory such as the Capital
Asset Pricing Model (assets respond to their own economic fundamentals as
well as overall market conditions, risk reduction through diversification
is achievable across asset classes) and others which may not be (enhanced
returns can be generated though "active" strategies such as relative value
trades and stock picking). The RORO phenomenon means these principles are
much less useful than they once were. Furthermore, and crucially for
investors, it provides a replacement framework within which they can
construct new and effective asset allocation strategies.
Immediate impact for HSBC can be measured in terms of client take-up.
Research is distributed via a web-site, and by an emailed web-link,
enabling active downloads to be tracked. The Head of FX Quantitative
Strategy at HSBC writes [A]: "In 2012, HSBC published over [text
removed for publication] research reports. Scored by distinct
hits, the report "RORO: Fixing a Broken Investment Process" was ranked 3rd
globally. [...] It is a testament to the importance of RORO to
traditional practitioners as well as `quants' and points to RORO
becoming `mainstream and widely relevant. [...] HSBC also
distributes research in online video format and two videos were produced
... Of over [text removed for publication] video releases in 2012, these
two videos were ranked 2nd and 3rd most watched."
As a consequence of client demand, the PCA-based graphical and
quantitative tools, as developed by the University of Oxford and HSBC, are
now updated weekly by HSBC and provided to clients on a subscription
basis. The immediate commercial impact for HSBC is exemplified in the
letter from the Head of FX Quantitative Strategy at HSBC [A], which states
[text removed for publication]. Trading businesses are high volume,
low margin operations. A higher ongoing volume of client business is thus
extremely valuable. Numbers are too commercially sensitive to state, but
are significant enough that HSBC has now launched a dedicated Emerging
Market version of the PCA-based tools to further its Asian, Latin American
and Middle Eastern franchises.
Deeper impact is seen in requests for in-depth project work by HSBC from
top-tier clients. "We also conducted bespoke research for individual
clients, including central banks, corporates and investment managers
looking to adapt their businesses to the RORO phenomenon. The combined
AUM [assets under management] of these clients totalled hundreds
of billions of dollars" states the Head of FX Quantitative Strategy
at HSBC [A].
The research has directly benefited the wider investment management
community, with many substantial investors using the HSBC RORO index as a
key quantitative tool for making investment decisions. As an example of
typical usage, the website of Institutional Asset Manager, reporting a
presentation [B] by Peter Rigg, Global Head of HSBC Alternative Investment
Group and an early adopter of the use of RORO, states: "Quite simply,
until the RORO Index shows signs of falling, Rigg does not envisage a
transition from Scenario 1 [relatively pessimistic] to Scenario
2 [cautiously optimistic]"; it goes on to explain that his
investment strategy will be determined by this signal: "`We're
currently positioned for Scenario 1 but we can move quickly into
Scenario 2 when required', said Rigg". HSBC AIM is the largest
Alternative manager in the UK with $30 Bn AUM.
The Global Chief Investment Officer of [text removed for publication]
writes (to the University of Oxford) [C]: "Your published research in
this area has been instrumental for practitioners endeavouring to
measure and adapt to this once-in-a-generation shift in market
structure. I consider your work to be groundbreaking and it has had
significant impact within the asset management community and beyond".
A Director at [text removed for publication] writes [D]: "[RORO] helped
my team better understand our positioning during a difficult time in the
markets", listing areas where [text removed for publication] uses
it, including stress testing positioning (analysis of portfolio behaviour
under extreme scenarios) and assisting clients in total portfolio
construction. A Senior Portfolio Manager at [text removed for
publication], states [E]: "The hallmark of the RORO phenomenon
was a dramatic increase in cross-asset correlations: this had profound
consequences for the asset management community. [...] the
insight we derived from your research has had a direct impact on the
construction methodologies we adopted for our funds."
Use of the RORO framework has now extended well beyond HSBC and other
professional investment managers. After featuring in specialist
publications such as Risk Magazine ("Everyone is perplexed by these
risk-on or risk-off days, where it feels like you can actually see the
correlation increase" [F], para 2) and FX Week (headline: Risk-on,
risk-off markets boost demand for active currency management [G], RORO
began to feature regularly in the generalist financial press, often with
explicit reference to the HSBC research team. There have been many
appearances in the Financial Times and Wall Street Journal, for example "In
the scale of Risk On/Risk Off trading days, this looked usual" [H]
from the FT and the WSJ headline "Bernanke's 'Risk-On, Risk-Off' Monetary
Policy" [I]; they include columns, blogs, feature articles and inclusion
in a Private Wealth Management supplement. The Financial Times has
recently added RORO to the official list of tags it uses to index its
website FT.com, where a search for RORO gives more than 50 results [J].
The RORO paradigm has now moved on to become a staple of mainstream
journalism. For example, articles in the Times (headline: "Risk on, risk
off as stock market's RoRo goes into sharp reverse" [K]) and the New York
Times Business Day `Your Money' section ("Why are markets so highly
correlated? The answer may be found in "risk on, risk off," a bit of
jargon favored by financial traders and strategists." [L]) are aimed at
mainstream retail audiences, while [M] looks at the repercussions of RORO
for retirement planning and saving for children's education. Likewise,
mainstream retail investor websites use the terminology routinely; for
example, in an article entitle Rising star fund managers,
Investor's Chronicle simply quoted Jason Hollands from Bestinvest:. "A
false call on the risk on/risk off trade could turn a manager from hero
to zero overnight" [N].
Sources to corroborate the impact
[A] Letter from Head of FX Quantitative Strategy at HSBC, describing the
development, use and impact of RORO in HSBC. Copy held by University of
[C] Letter from CIO, [text removed for publication]. Copy held by
University of Oxford.
[D] Letter from Director at [text removed for publication] Copy
held by University of Oxford.
[E] Letter from Senior Portfolio Manager, [text removed for
publication]. Copy held by University of Oxford.
[H] James Mackintosh, 'The Short View', The Financial Times, 5
[I] http://online.wsj.com/article/SB10000872396390443524904577649793013124710.html?KEYWORDS=%22risk+on%22+%22risk+off%22 — note the attached tags. 2012.
[L] http://www.nytimes.com/2012/01/29/your-money/how-long-can-the-stock-market-forget-about-the-pain.html?, 2012.
[C]-[E] confirm the reach and significance of the economic impact of RORO
among major fund managers. [F]-[N] corroborate the reach and significance
of the societal impact of RORO. The University of Oxford holds copies of