Commodity carry

December 8, 2018

Across assets, carry is defined as return for unchanged prices and is calculated based on the difference between spot and futures prices (view post here). Unlike other markets, commodity futures curves are segmented by obstacles to intertemporal arbitrage. The costlier the storage, the greater is the segmentation and the variability of carry. The segmented commodity curve is shaped prominently by four factors: [1] funding and storage costs, [2] expected supply-demand imbalances, [3] convenience yields and [4] hedging pressure. The latter two factors give rise to premia that can be received by financial investors. In order to focus on premia, one must strip out apparent supply-demand effects, such as seasonal fluctuations and storage costs. After adjustment both direction and size of commodity carry should be valid, if imprecise, indicators of risk premia. Data for 2000-2018 show clear a persistent positive correlation of the carry with future returns.

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Understanding the correlation of equity and bond returns

December 1, 2018

The correlation of equity and high grade sovereign bond returns is a powerful driver of portfolio construction and the term premia of interest rates. This correlation has turned from positive in the 1970s-1990s to negative in the 2000s-2010s, on the back of similar shifts in the correlation between inflation and economic growth and between inflation and real interest rates. The structural correlation flip has given rise to a risk parity investment boom and contributed to the compression in long-term yields. Both theoretical and empirical analysis suggests that negative equity-bond correlation is due largely to pro-cyclical inflation, i.e. higher inflation coinciding with better economic performance, as opposed counter-cyclical inflation or stagflation. Inflation is more likely to be pro-cyclical if it is low or in deflation (view post here) and driven by demand rather than supply shocks.

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Realistic volatility risk premia

November 17, 2018

The volatility risk premium compensates investors for taking volatility risk. Conceptually it is based on the difference between options-implied and expected realized volatility. In equity markets this premium should be positive in the long run and fluctuate overtime depending on the market’s willingness to pay for protection against future changes in price volatility. In practice, measuring the premium overtime is challenging, particularly because expected realized volatility is not known. Using recent realized volatility as a proxy can be highly misleading. However, a realistic estimate can be constructed by considering the trade-off between timeliness and noise ratio of recent price changes and the long-term mean reversion of volatility. This “realistic” volatility risk premium has been positively correlated with subsequent daily volatility index future returns.

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Variance term premia

October 27, 2018

Variance term premia are surcharges on traded volatility that compensate for bearing volatility risk in respect to underlying asset prices over different forward horizons. The premia tend to increase in financial market distress and decrease in market expansions. Variance term premia have historically helped predicting returns on various equity volatility derivatives. The premia themselves can be estimated based on variance swap forward rates and their decomposition into expected underlying price variance and risk premia. In particular, the variance term premia are obtained as the difference between forward swap rates and realized volatility forecasts, whereby the latter are related to a “volatility state vector”.

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Multiple risk-free interest rates

October 6, 2018

Financial markets produce more than one risk-free interest rate. This is because there are several separate market segments where structured trades replicate such a rate. Differences in remuneration arise for two reasons. First, financial frictions can prevent arbitrage. Second, some risk-free assets pay additional convenient yields, typically by virtue of their liquidity and suitability as collateral. Put simply some “safe assets” have value beyond return. U.S. government bonds, in particular, seem to provide a sizable consistent convenience yield that tends to soar in crisis. This suggests that there are arbitrage opportunities for investors that are flexible, impervious to convenience yields and tolerant towards temporary mark-to-market losses.

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Earnings yields, equity carry and risk premia

September 8, 2018

Forward earnings yields and equity carry are plausible indicators of risk premia embedded in equity index futures prices. Data for a panel of 25 developed and emerging markets from 2000 to 2018 show that index forward earnings yields have been correlated with market uncertainty across countries and time. Earnings yields have been highest in emerging countries. However, equity carries have not, because they depend on local funding conditions and only indicate the country risk premium that is specific to equity. Both yield and carry metrics display convincing and consistent positive correlation with subsequent index futures returns. Simulations show that for proper equity long-short strategies active volatility adjustment of both signals and positions is essential in order to balance risk premia with the actual state of riskiness of the market.

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What variance swaps tell us about risk premia

August 4, 2018

Variance swaps are over-the-counter derivatives that exchange payments related to future realized price variance against fixed rates. Variance swaps help estimating term structures for variance risk premia, i.e. market premia for hedging against volatility risk based in the difference between market-priced variance and predicted variance. The swap rates conceptually produce more accurate estimates of variance risk premia than implied volatilities from the option markets. An empirical analysis suggests that swap-based variance risk premia are positive and increasing in maturity. A drop in equity prices or rise in credit spreads pushes variance risk premia higher. The effect is strongest for short maturities up to 6 months, but more persistent for long maturities.

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The importance of volatility of volatility

July 21, 2018

Options-implied volatility of U.S. equity prices is measured by the volatility index, VIX. Options-implied volatility of volatility is measured by the volatility-of-volatility index, VVIX. Importantly, these two are conceptually and empirically different sources of risk. Hence, there should also be two types of risk premia: one for the uncertainty of volatility and for the uncertainty of variation in volatility. The latter is often neglected and may reflect deep uncertainty about the structural robustness of markets to economic change. A new paper shows the importance of both risk factors for investment strategies, both theoretically and empirically. For example, implied volatility and “vol of vol” typically exceed the respective realized variations, indicating that a risk premium is being paid. Also, high measured risk premia for volatility and “vol-of-vol” lead to high returns in investment strategies that are “long” these factors.

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FX carry strategies (part 2): Hedging

June 16, 2018

There is often a strong case for hedging FX carry trades against unrelated global market factors. It is usually not difficult to hedge currency positions – at least partly – against global directional risk and against moves in the EURUSD exchange rate. The benefits of these hedges are [1] more idiosyncratic and diversifiable currency trades and, [2] a more realistic assessment of the actual currency-specific subsidy or risk premium implied by carry, by applying hedge costs to the carry measure. Empirical analysis suggests that regression-based hedging improves Sharpe ratios, reduces risk correlation and removes downside skews in the returns of global FX carry strategies. Hedging works well in conjunction with “economically adjusted” FX carry and even benefits the performance of relative FX carry strategies that have no systematic risk correlation to begin with.

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FX carry strategies (part 1)

June 9, 2018

FX forward-implied carry is a valid basis for investment strategies because it is related to policy subsidies and risk premia. However, it also contains misdirection such as rational expectations of currency depreciation. To increase the signal-noise ratio FX carry should – at the very least – be adjusted for expected inflation differentials and external deficits. Even with such plausible adjustments FX carry is a hazardous signal for directional trades because it favours positions with correlated risks and great sensitivity to global equity markets. By contrast, relative adjusted carry has been a plausible and successful basis for setting up relative normalized carry trades across similar currencies. It has historically produced respectable Sharpe ratios and low directional risk correlation. Such strategies seem to generate alpha and exploit alternative risk premia alike.

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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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