From Risk Premia to Constraints: How Markets Really Clear
The textbook framework — risk premia as compensation for bearing systematic risk — does a respectable job of organizing returns in calm regimes. But in stress, a different engine often dominates. Prices clear less as a referendum on fair value and more as a function of balance sheet constraints: leverage, margining, liquidity, mandates, and who is forced to transact first.
In those conditions, equilibrium is frequently balance-sheet clearing, not consensus clearing. A mispricing is only an opportunity if you can carry it. The horizon that matters is not your DCF horizon; it is your funding-and-governance horizon.
In practice, this means separating information from forced flows, sizing positions to survive the path to being right, and treating liquidity, cash, and governance as core risk variables.
When “Safe Assets” Stop Behaving Safely: Prices Under Constraint
Two recent episodes show how prices are set when constraints, not fundamentals, dominate.
1) UK Gilts, September 2022
The UK Gilt episode in late September 2022 is a compact illustration. After the government’s “mini-budget,” long-dated gilt yields repriced violently. What turned repricing into dysfunction was not merely disagreement about fundamentals; it was plumbing. Leveraged liability-driven investment (LDI) strategies faced rapid margin and collateral calls and had to raise cash quickly. In a thinning market, that urgency created forced selling into illiquidity; an endogenous feedback loop that ultimately required the Bank of England to intervene with temporary and targeted long-dated gilt purchases “to restore orderly market conditions,” on “whatever scale is necessary.”
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