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IPFS News Link • Economy - Economics USA

Exter's Inverted Pyramid Of Risk

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Developed in the 1970s, Exter's Inverted Pyramid of Risk remains as relevant as ever, especially in assessing assets through the lens of counterparty risk.

The pyramid serves as a guide to comprehend the risks facing America, particularly in anticipation of what may be the most severe credit crisis in the coming decade or two, centered around the USD crisis.

Exter's Inverted Pyramid of Risk

Organized from the most illiquid and highest counterparty risk assets to the least risky and most liquid, the layers of the inverted pyramid provide a unique perspective that builds from the mindset of a counterparty-risk sensitive investor. A swift glance at the pyramid reveals that the removal of any assets on the lower end (the more narrow base), will lead to the downfall of everything associated with it on the higher end, akin to a collapsing Jenga tower.

Derivatives and Unfunded Government Liabilities (White Top Layer): 

This top layer comprises assets marked by the utmost risk and volatility, encompassing derivatives such as options, CFDs, and futures. While these instruments arguably serve limited professional purposes like hedging and speculation, they are met with considerable skepticism. Any form of financial turbulence can not only wipe out a participant's initial investment but also entail additional losses! Warren Buffett notably dubbed them 'financial weapons of mass destruction.' It's prudent for most to never engage with derivative financial products, echoing the wisdom found in the proverb: "Can a man take fire to his chest and his clothes not be burned?'"

Private Business Equity, Real Estate, and Non-Monetary Commodities (Red Layer): This layer includes genuinely productive assets and commodities for economic growth but given their relation to the credit markets they prove highly sensitive during a deflationary recession, as exemplified by the 2008 financial crisis. It emphasizes the vulnerability of these asset classes to the credit squeeze associated with what many refer to as the 'business cycle,' a phenomenon we contend is more influenced by central planning, specifically the 'Fed cycle.' Despite their inherent productivity, these assets remain susceptible to the capricious nature of centrally planned and interventionist policies and are some of the first to make headlines during a crisis.