The View | Where to find Alpha in the era of zero interest rates

Asset bubbles driving equities and real estate asset prices have been observed as the direct outcome of sustained zero interest rate policies, particular in the US and EU over the last 10 years.

Even as interest rates are rising, an even greater threat hasn’t been highlighted – the inability of financial risk models in banks, asset managers and financial advisors to accurately understand and forecast how investments, indices and markets will react to rising rates.

Their risk models are vulnerable because a decade of zero interest rates have never occurred before in financial and economic history. No one possesses accurate historical data to predict the future. And quantitative models and algorithms heavily depend on historical data for forecasting risk.

“There are no models that are able to accurately capture the effect of rising interest rates. You need to reach back to the period before quantitative easing began,” said Axioma’s managing director Olivier d’Assier, pointing out the key finding of the risk consultant’s research.

“Even if you use the effect of rising interest rates on equity prices in the period from 1994, they won’t reflect today’s correlations as the market was different. You can do this for the US stock market, but not for the EU as there is no similar historical data available for the Euro.”

This poses potentially disastrous implications for portfolio and risk management if and when interest rates surge and return to normal after a decade of distorting asset valuation. The absence of normative market risk pricing and historical interest rate data disturbs the entire way so called “Alpha” (excess returns) has been hunted by asset managers.