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The Difference Between Risk & Uncertainty in Finance
Blu Putnam and Erik Norland, CME Group
AT A GLANCE
- Uncertainty is difficult to quantify. The effect the Federal Reserve’s actions to fight inflation may take in the coming year is a recent stark example
- With heightened uncertainty, there are often two highly distinct scenarios or potential outcomes competing with each other in the minds of market participants
In the latest episode of The Economists, CME Group Chief Economist Blu Putnam and Senior Economist Erik Norland explore the differences between risk and uncertainty in financial markets. A transcript of their discussion follows:
Blu Putnam: The words risk and uncertainty are often used interchangeably in spoken conversation. In finance, however, there is a critical distinction. Risk is considered amenable to being quantified such as using an implied volatility from options markets to assess the downside potential of a given financial market exposure. By contrast, uncertainty belongs to uncharted territory that is exceptionally difficult to quantify. For example, whether it is an inflation environment we have not seen in four decades or a shift by the Federal Reserve to raising rates and fighting inflation instead of providing a backstop to bonds and equities with massive asset purchases, transitions involving a radically different environment may dramatically raise the degree of uncertainty and reduce the confidence we have in quantifying the risks.
Erik Norland: The longer-term financial market implications of the shift in focus at the Federal Reserve to fight inflation is especially difficult to quantify. In the first part of 2022, the Fed was buying about $120 billion of U.S. Treasuries and Mortgage-Backed Securities every month, commonly known as quantitative easing or QE. Starting in June of 2022, the Fed started to incrementally shrink its balance sheet, known as quantitative tightening or QT. At the same time, the Fed has begun raising the upper-end of its federal funds rate target range from 0.25% at the beginning of 2022, with federal funds futures suggesting the rate will find itself in the 3%-plus territory in early 2023.
Not surprisingly, as the Fed’s focus shifted to inflation-fighting, U.S. equity and bond markets took a tumble in the first half of 2022, as market participants struggled to figure out if a recession was coming soon, how consumers would react, what would happen to the job market, etc. With the Fed’s long-run plans still in doubt, uncertainty about what might happen in the coming calendar year remains at elevated levels.
Blu Putnam: The elevated degree of market uncertainties relative to quantifiable risks is exponentially complicated when there are multiple major transitions happening at the same time. Let’s take an example from physics. We understand the liquid state and we understand the gaseous state. Image the transition water goes through as it boils and leaves the liquid state and turns into a gaseous state. The bubbles, or chaos in the boiling water are all at the surface or boundary of the transition. Transition analysis is exceptionally difficult and with transitions in climate, geo-politics, post-pandemic pattern shifts, inflation, and demography, just to name a few, happening simultaneously and interacting with each other, it is no wonder we are navigating a world of elevated uncertainty and struggling to quantify the risks.
Erik Norland: Heightened uncertainty puts the emphasis on more sophisticated methods of managing risky exposures, because there are often two very different and highly distinct scenarios or potential outcomes competing with each other in the minds of market participants. Markets will price the capital-weighted average of the probabilities of each potential outcome – that is, split the difference. Eventually, only one outcome will prevail, and there is the possibility that prices in an affected market might move abruptly to reflect the prevailing outcome and the resolution of the uncertainty. This particular kind of event risk may be better managed with options to deal with heightened probability of abrupt price moves rather than futures where the objective is typically to manage directional risks.
The Economists is a video series covering the industries and events shaping global economics with a special focus on post-pandemic economic realities.