Tiered reserve systems

April 6, 2019

Negative monetary policy rates can undermine financial transmission, because they encourage cash hoarding and reduce the profitability of traditional banking. This danger increases with depth and duration of negative interest rate policies. Therefore, some countries (Japan, Sweden, Switzerland, and Denmark) have introduced tiered reserve systems, effectively exempting a part of the banking system’s excess reserves from negative rates. Importantly, a tiered reserve system is now also considered by the European Central Bank for the second largest currency area in the world. Since tiered reserve systems are on the verge of “going mainstream” their impact on asset pricing formulas and quantitative trading strategies deserves careful consideration.

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Survival in the trading factor zoo

March 30, 2019

The algorithmic strategy business likes quoting academic research to support specific trading factors, particularly in the equity space. Unfortunately, the rules of conventional academic success provide strong incentives for data mining and presenting ‘significant’ results. This greases the wheels of a trial-and-error machinery that discover factors merely by the force of large numbers and clever fitting of the data: some 400 trading factors have so far been published in academic journals (called the “factor zoo”). The number of unpublished and rejected tested factors is probably a high multiple of that. With so many tryouts, conventional significance indicators are largely meaningless and misleading. As with the problem of overfitting (view post here), the best remedies are plausible mathematical adjustments and reliance upon solid prior theory.

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Signaling systemic risk

March 23, 2019

Systemic financial crises arise when vulnerable financial systems meet adverse shocks. A systemic risk indicator tracks the vulnerability rather than the shocks (which are the subject of ‘stress indicators’). A systemic risk indicator is by nature slow-moving and should signal elevated probability of financial system crises long before they manifest. A recent ECB paper proposed a practical approach to building domestic systemic risk indicators across countries. For each relevant categories of financial vulnerability, one representative measure is chosen on the basis of its early warning qualities. The measures are then normalized and aggregated linearly. In the past, aggregate systemic risk indicators would have shown vulnerability years ahead of crises. They would also have indicated the depth of ensuing economic downturns.

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How to estimate risk in extreme market situations

March 16, 2019

Estimating portfolio risk in extreme situations means answering two questions: First, has the market entered an extreme state? Second, how are returns likely to be distributed in such an extreme state? There are three different types of models to address these questions statistically. Conventional “extreme value theory” really only answers the second question, by fitting an appropriate limiting distribution over observations that exceed a fixed threshold. “Extreme value mixture models” simultaneously estimate the threshold for extreme distributions and the extreme distribution itself. This method seems appropriate if uncertainty over threshold values is high. Finally, “changepoint extreme value mixture models” even go a step further and estimate the timing and nature of changes in extreme distributions. The assumption of changing extreme distributions across episodes seems realistic but should make it harder to apply the method out-of-sample.

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The dollar as barometer for credit market risk

March 9, 2019

The external value of the USD has become a key factor of U.S. and global credit conditions. This reflects the surge in global USD-denominated debt in conjunction with the growing importance of mutual funds as the ultimate source of loan financing. There is empirical evidence that USD strength has been correlated with credit tightening by U.S. banks. There is also evidence that this tightening arises from deteriorating secondary market conditions for U.S. corporate loans, which, in turn, are related to outflows of credit funds after USD appreciation. The outflows are a rational response to the negative balance sheet effect of a strong dollar on EM corporates in particular. One upshot is that the dollar exchange rate has become an important early indicator for credit market conditions.

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How salience theory explains the mispricing of risk

March 2, 2019

Salience theory suggests that decision makers exaggerate the probability of extreme events if they are aware of their possibility. This gives rise to subjective probability distributions and undermines conventional rationality. In particular, salience theory explains skewness preference, i.e. the overpricing of assets with a positive skew and the under-pricing of contracts with a negative skew. There is ample evidence of skewness preference, most obviously the overpayment for insurance contracts and lottery tickets. In financial markets, growth stocks with positively-skewed expected returns have historically been overpriced relative to value stocks. This is important for macro trading. For example, a specific publicly discussed disaster risk should pay an excessive premium, and short-volatility strategies in times of fear of large drawdowns for the underlying should have positive expected value.

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Understanding China’s “financial policy”

February 23, 2019

In most developed countries macroeconomic management is the domain of separate fiscal and monetary policies. In China, the focus is on “financial policy”, a combination of credit, monetary and regulatory policies with powerful direct effects on growth and stability. This “financial policy” has critically shaped the structural development of the economy, fostering particularly state-owned enterprises, heavy industry, and real estate. It has left the economy with a difficult legacy of inefficient credit allocation, bloated shadow banking, and financial systemic risk in the real estate sector. Reforms since 2016 seek to normalize China’s macroeconomic policies but have created severe tensions between the objectives of deleveraging and sufficient growth.

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Algorithmic strategies: managing the overfitting bias

February 16, 2019

The business of algorithmic trading strategies creates incentives for model overfitting and backtest embellishment: researchers must pass Sharpe ratio thresholds for their strategies to be considered, while managers lack interest in realistic simulations of ideas. Overfitting leads to bad investment decisions and underestimated risk. Sound ethical principles are the best method for containing this risk (view post here). Where these principles have been compromised one should assume that all ‘tweaks’ to the original strategy idea that are motivated by backtest improvement contribute to overfitting. Their effects can be estimated by looking at the ratio of directional ‘flips’ in the trading signal. Overfitting typically increases with the Sharpe ratio targets of the business and the scope for applying ‘tweaks’ to the strategy. Realistic strategy performance expectations should be based on a range of plausible strategy versions, not on an optimized one.

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Understanding dollar cross-currency basis

February 9, 2019

Covered interest parity is an arbitrage condition that equalizes costs of direct USD funding and of synthetic USD funding through FX swaps. Deviations are called dollar cross-currency basis and have become a common occurrence since the great financial crisis. A negative dollar basis means direct funding in USD – if accessible – is cheaper than synthetic funding via swaps. An apparent structural cause of the dollar basis has been regulatory tightening, which has increased balance sheet costs of arbitrage. Moreover, research has found several short-term factors. Thus, a negative dollar basis has been linked to aggregate USD strength, rising market volatility, deteriorating FX market liquidity, monetary tightening in the U.S. relative to other countries, and a decrease of funds in the USD money market. In most of these cases, the dollar basis represents dollar funding conditions not captured by published interest rates and is a valid trading signal.

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Why herding is the death of momentum

February 2, 2019

Momentum trading, buying winning assets and selling losing assets, is a most popular trading strategy. It relies on sluggish market adjustment, allowing the trader to follow best-informed investors before the more inert part of the market does. Herding simply means that market participants imitate each others’ actions. Herding accelerates and potentially exaggerates market adjustments. The more quickly the herd moves, the harder it becomes to follow informed leaders profitably. In a large agile herd, sluggish adjustment gives way to frequent overreaction. Momentum strategies fail. This suggests that popularity and commoditization of momentum strategies (and trend-following) are ultimately self-defying. Conditioning momentum strategies on the estimated degree of herding should produce superior investment returns.

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Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for two decades. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.

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