Beware of over-confidence

Prop traders finally have something to cheer about. After a year of record low volatility in 2005, things have become distinctly lively over the past month. Emerging market equities have plunged, commodity prices have tumbled and rates markets have been jittery amid signs that inflation is picking up.

The European Central Bank has now raised interest rates three times since December, taking its key rate to 2.75%, while the US Federal Reserve will almost certainly have increased interest rates by a further 25 basis points - the seventeenth consecutive rise - by the time you pick up your copy of Risk. On top of that, the Bank of Japan ended its quantitative easing policy in March, and there are signs the central bank will not dilly-dally in raising interest rates.

One likely consequence of a Japanese rate rise is an end to the once-popular carry trade - where investors borrow at low rates in yen, and invest in higher-yielding currencies such as the Australian and New Zealand dollars. Already, many of these trades have been unwound - something analysts say contributed to the rapid depreciation of the New Zealand dollar and Icelandic krona earlier this year.

Interestingly, localised shocks such as the one in Iceland - where the depreciating krona and spiking inflation has forced the central bank to raise interest rates by 1.75% since the start of this year - has meant some dealers are increasingly confident that the financial markets are now a lot better prepared to deal with market shocks.

And they have a point. The growth of the hedge fund industry, for instance, means there are a wider variety of participants willing to take on risk and provide liquidity in stressed markets.

However, one central banker who spoke to Risk recently reckons these sorts of mini-events have led to overconfidence in the markets. He was very concerned that risk is being under-priced and is not reflective of the current economic cycle.

The central banker's number-one concern was that a major market event could cause a ripple effect across the financial system, causing correlations to shift and liquidity to dry up. He pointed to the complexity and leverage of many of the structured products that have emerged in the past few years - products that haven't been tested in a stress environment.

As a result, it's more important than ever that firms develop robust stress tests involving a wider range of scenarios. Again here, he expressed concern, noting that some firms have fallen behind the curve in fully embedding stress tests into their risk management processes.

Could the events of the past month lead to the major market event the central banker is worried about? The chances are, probably not. But perhaps banks should just be a little more cautious, a little less confident, improve stress tests and look again at margining practices.

Nick Sawyer, Editor.