Finding implicit subsidies in financial markets

May 26, 2018

Implicit subsidies in financial markets can be defined as expected returns over and above the risk free rate and conventional risk premia. While conventional risk premia arise from portfolio optimization of rational risk-averse financial investors, implicit subsidies arise from special interests of market participants, including political, strategic and personal motives. Examples are exchange rate targets of governments, price targets of commodity producers, investor relations of institutions, and the preference for stable and contained portfolio volatility of many households. Implicit subsidies are more like fees for services than compensation for standard financial risk. Detecting and receiving such subsidies creates risk-adjusted value. Implicit subsidies are paid in all major markets. Receiving them often comes with risks of crowded positioning and recurrent setbacks.

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Commodity pricing

May 19, 2018

A new paper combines two key aspects of commodity pricing: [1] a rational pricing model based on the present value of future convenience yields of physical commodity holdings, and [2] the activity of financial investors in form of rational short-term trading and contrarian trading. Since convenience yields are related to the scarcity of a commodity and the value of inventories for production and consumption they provide the fundamental anchor of prices. The trading aspect reflects the growing “financialization” of commodity markets. The influence of both fundamentals and trading is backed by empirical evidence. One implication is that adjusted spreads between spot and futures prices, which partly indicate unsustainably high or low convenience yields, are valid trading signals.

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Fixed income carry as trading signal

April 28, 2018

Empirical evidence for 27 markets suggests that carry on interest rate swaps has been positively correlated with subsequent returns for the past two decades. Indeed, a naïve strategy following carry as signal has produced respectable risk-adjusted returns. However, this positive past performance masks the fundamental flaw of the carry signal: it disregards the expected future drift in interest rates and favours receiver position in markets with very low real rates. In the 2000s and 2010s this oversight mattered little because inflation and yields drifted broadly lower. If the inflation cycle turns or just stabilizes, however, short-term rates normalization should become very consequential. Indeed, enhancing the IRS carry signal by a plausible medium term drift in short rates has already in the past produced more stable returns and more convincing actual “alpha”.

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The correlation risk premium

April 21, 2018

The correlation risk premium is a premium for uncertainty of future correlation of securities among each other or with a benchmark. A rise in correlation reduces diversification benefits. The common adage that in a crash ‘all correlations go to one’ reflects that there is typically not much diversification in large market downturns and systemic crises, except through outright shorts. Correlation risk premia can be estimated based on option prices and their implied correlation across stocks. There is evidence that these estimates are useful predictors for long-term individual stock performance, over and above the predictive power of variance risk premia.

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Gold: risk premium and expected return

December 23, 2017

An empirical paper suggests that the risk premium and excess return on gold have been time-varying and predictable, also out-of-sample. The key predictors have been the variance risk premium and the jump risk premium of gold. Gold has historically also served as a hedge and “safe haven” for equity and bond investments, but this could not have been expected based on forecasting models. Common sense suggests that the hedge value of gold depends on the dominant market shock. For example, gold hedges against inflationary policies but not against rising real interest rates.

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The downside variance risk premium

December 9, 2017

The variance risk premium of an asset is the difference between options-implied and actual expected return variation. It can be viewed as a price for hedging against variation in volatility. However, attitudes towards volatility are asymmetric: large upside moves are fine while large downside moves are scary. A measure of aversion to negative volatility is the downside variance risk premium, the difference between options-implied and actual expected downside variation of returns. It is this downside volatility risk that investors want to protect against and whose hedging price is a valid and apparently robust indicator of future returns. Similarly, the skewness risk premium, the difference between upside and downside variance risk premia, is also a powerful predictor of markets.

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The 1×1 of risk perception measures

December 1, 2017

There are two reasons why macro traders watch risk perceptions. First, sudden spikes often trigger subsequent flows and macroeconomic change. Second, implausibly high or low values indicate risk premium opportunities or setback risks. Key types of risk and uncertainty measures include [1] keyword-based newspaper article counts that measure policy and geopolitical uncertainty, [2] survey-based economic forecast discrepancies, [3] asset price-based measures of fear and uncertainty and [4] derivatives-implied cost of hedging against directional risk and price volatility.

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Fear of drawdown

August 19, 2017

Experimental research suggests that probability of outright loss rather than volatility is the key driver of investor risk perceptions. Moreover, fear of drawdown causes significant differences of prices for assets with roughly equal expected returns and standard deviations. Investors forfeit significant expected returns for the sake of not showing an outright loss at the end of the investment period. This suggests that trading strategies with a high probability of outright losses produce superior volatility-adjusted returns. Rational acceptance of regular periodic drawdowns or “bad years” should raise long-term Sharpe ratios.

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Covered interest parity: breakdowns and opportunities

August 12, 2017

Since the great financial crisis conventional measures of the covered interest parity across currencies have regularly broken down. Two developments seem to explain this. First, money markets have become more segmented, with top tier banks having access to cheaper and easier funding, particularly in times distress. Second, FX swap markets have experienced recurrent imbalances and market makers have been unable or unwilling to buffer one-sided order flows. Profit opportunities arise for some global banks in form of arbitrage and for other investors in form of trading signals for funding liquidity risk premia.

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Global market portfolio: construction and performance

July 22, 2017

A representative market portfolio can be built as the capitalization-weighted average of global equity, real estate and bonds. From 1960 to 2015 such a portfolio would have recorded a dollar-denominated nominal compound return of 8.4%, a real (inflation-adjusted) return of 4.4% and a Sharpe ratio of 0.7. Equity has delivered superior absolute returns, while bonds have delivered superior risk-adjusted returns, consistent with the “low risk effect” theory (view post here). The disinflationary period delivered more than double the returns of the inflationary period. Plausibility and empirical evidence suggest that the market portfolio is not efficient.

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asset management Asset Purchase Program banks bond returns bond yields bubbles capital regulation central counterparty clearing China collateral commodities credit returns default ECB economic data EM equity returns euro area crisis Fed financial crisis FX FX interventions FX returns government debt government deficits herding inflation information insurances Japan leverage liquidity machine learning market turmoil price factors regulation risk management shadow banking statistical methods term structure trend following variance risk premium VIX volatility ZLB
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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 over eighteen years. 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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