INSIGHTS: Investment, Financial System, Real Output and Macro-Risk Management

Volume 13, Number 1, First Quarter 2015

Thomas S. Y. Ho and Sang Bin Lee

Loan underwriting standards and quantitative easing are examples of macro-risk management tools that affect the financial sector, which in turn affects real sector outputs. And therefore asset returns, real sector outputs, financial sector, and macro-risk management are interrelated. This paper shows that investors need to understand these relationships to enhance investment performance.

Recently, a macro-financial model (Ho et al., 2012, 2013; Ho and Lee, 2015a, 2015b) suggests that financial regulations must be dynamic to ensure optimality of real sector outputs while maintaining safety and soundness of the financial system. Since the real output exhibits a decreasing marginal increase in real growth with an increase in real output risk, an optimal macro-financial leverage exists, given risk and return preference of an economy. Macro-risk management is important to a dynamic economy.

This paper suggests a framework for policy makers to implement macro-risk management and for investors to incorporate changing financial regulations in their investment process.