They only take conservative approaches, investing on only safe and uncontingent claims, to protect themselves from worst-case scenarios related to the risk that they do not understand, which further deteriorates asset prices and financial market.
Mechanism[ edit ] Flight-to-quality episodes are triggered by unusual and unexpected events. Such a portfolio shift further exposes the financial sector to negative shocks. Acharya et al  show that during financial turmoil liquid banks in interbank loan markets do not lend their liquidity to illiquid banks, nor hoard liquidity for precautionary reasons, but, rather, hoard them to purchase assets at distress prices.
Investors faced with tightened balance sheet and increased risk and uncertainty aversion reduce their investment and shift their portfolio only towards safer projects and high quality borrowers.
Examples of high-risk-high return investments include options, penny stocks and leveraged exchange-traded funds ETFs. Under Knightian uncertainty, investors respond by disengaging from risky activities and hoarding liquidity while reevaluating their investment models.
Measuring Singular Risk in Context and Portfolio Risk Level When an investor considers high-risk-high-return investments, the investor can apply the risk-return tradeoff to the vehicle on a singular basis as well as within the context of the portfolio as a whole. A model of strategic or speculative behaviors of liquid investors provides another mechanism that explains flight-to-quality phenomenon.
Worsening of initial impacts developed into a flight-to-quality pattern, as the unusual and unexpected features of the events made market participants more risk and uncertainty averse, incurring more aggressive reactions compared to responses during other shocks.
While excessive risk-taking can be a source of financial turmoil, insufficient risk-taking can severely disrupt credit and other financial markets during a financial turmoil. Treasury bond is less risky and more liquid than a corporate bond.
For example, a portfolio composed of all equities presents both higher risk and higher potential returns. However, data shows that during the flight-to-quality episodes worsening relative position of banks compared to the very safe assets.
Thus, most theoretical studies that attempt to explain underlying mechanisms take both flight-to-quality and flight-to-liquidity into account.
Assets that are subject to the flight to quality pattern are also subject to flight to liquidity. Tightening external financing for lower quality borrowers may extend to real consequences of output loss and higher unemployment, therefore exacerbate business cycle.
Within an all-equity portfolio, risk and reward can be increased by concentrating investments in specific sectors or by taking on single positions that represent a large percentage of holdings.
The loan from the central bank to distressed banks would improve their outside option in bargaining. For instance, a guarantee issuance by government or loans to distressed private sectors would sustain deteriorating asset prices, bring confidence back in financial market, and prevent fire sale of assets.
Empirical Studies[ edit ] Since flight-to-quality phenomenon implies a shift in investing behavior towards some safe group of assets from risky assets, efforts to find evidence on flight-to-quality have been concentrated on analyzing widening yields or quantity changes between two assets.
Flight-to-quality is also observable within a safe group of assets. The argument for government intervention is that flight-to-quality phenomenon is a result of insufficient risk taking generated by Knightian uncertainty.
Investors use the risk-return tradeoff as one of the essential components of each investment decision, as well as to assess their portfolios as a whole. A phenomenon that occurs with flight-to-quality is flight-to-liquidity.
The initial effects of these events were a fall in asset prices and aggregate quantity of liquidity in financial market which deteriorated balance sheets of both borrowers and investors.
When an unusual and unexpected event incurs losses, investors find that they do not have a good understanding about the tail outcome that they are facing and treat the risk as Knightian uncertainty.
The externality is generated when in presence of illiquid market, each firm forced to sell illiquid assets depresses prices for everyone else but does not take this effect into account in its decision-making.
Policy Implications[ edit ] A moral hazard concern generally provides a rationale that government should not intervene in a financial crisis. For example, a penny stock position may have a high risk on a singular basis, but if it is the only position of its kind in a larger portfolio, the risk incurred by holding the stock is minimal.
That said, the risk-return tradeoff also exists at the portfolio level. Beber et al  make explicit distinction between flight-to-quality and flight-to-liquidity and find relative importance of liquidity over credit quality rises during flight-to-quality episodes. Brunnermeier and Pedersen  study strategic behaviors of liquid traders when they know that other traders need to liquidate their positions.
Investors realized that they did not have good understanding about mortgage-backed securities which were newly adopted. Thus less efficient asset sales would not be necessary and liquid banks would not be able to behave monopolistically.
This suggests that banks tend to be seen as safe havens in periods of turmoil. A defining feature of flight-to-quality is insufficient risk-taking by investors.
Gertler and Gilchrist  find similar result of relative proportion of loans being increased to larger firms, and Oliner and Rudebusch  find new loans made to safer projects are countercyclical during flight-to-quality episodes. For example, if an investor has the ability to invest in equities over the long termthat provides the investor with the potential to recover from the risks of bear markets and participate in bull markets, while if an investor can only invest in a short time frame, the same equities have a higher risk proposition.
Caballero and Krishnamurthy  show that central bank acting as a lender of last resort would be effective when both balance sheet and information amplifier mechanisms are at work. Liquidation of assets and withdrawals from financial market were severe, which made a risky group of borrowers have difficulties rolling over their liabilities and financing new credits.
A recent development in theory explains various mechanisms which led to enhanced initial effects of a flight-to-quality pattern. Krishnamurthy compares on-the-run and off-the-run treasury bonds to find higher spreads on off-the —run bonds are associated with higher spread between commercial paper and Treasury bonds.
One reason why the two appear together is that in most cases risky assets are also less liquid. The impact of the degrees of operating and financial leverage on systematic risk of common stock. Journal of Financial and Quantitative Analysis, (March) Journal of Financial and Quantitative Analysis, (March) For example, a penny stock position may have a high risk on a singular basis, but if it is the only position of its kind in a larger portfolio, the risk incurred by holding the stock is minimal.
24 Journal of Financial and Strategic Decisions the data bases used in prior studies. And third, different market indices are used to generate accounting betas where some of the previous studies used only the accounting return of their sample as a proxy for the market ind ex.
2 The literature review presented in the next section provides an overview of the results of previous studies that. Ranking of Commercial Banks in Uganda: A Comparative Analysis profitability ratios of Uganda commercial banks. Literature review factors affecting the performance of domestic Manish Kumar () examined the most profitable is to be paid to each outstanding share of common stock.
Literature Review The literature on the effects of derivatives use on bank profitability and risk is somewhat volatility of common stock return (such as Hassan et al., a and Br ewer et al., ) and implied volatility which measures the investors’ perspectives on the commercial banks risk level (such as Hassan et al., a and Li.
market, which has not changed is the 'risk' involved in investing in corporate securities. Managing the risk is emerging as an important function of both large scale and small-scale investors.
Risk management of investing in corporate securities is under active and extensive discussion among academicians and capital market operators.Literature review on risk and return analysis on common stock of commercail banks