The rise in risk spreads

July 6, 2019

A risk spread is a premium for bearing economic risk of an investment, paid over and above the short-term real interest rate. Over the past 30 years, risk spreads in the U.S. have increased significantly and consistently: while real interest rates on ‘safe’ bonds and deposits have collapsed, returns on private capital have remained roughly stable. Macroeconomic research suggests that this secular rise in risk spreads owes mainly to higher risk premia charged by financial markets and higher monopolistic rents extracted by companies. The strategic implication for rational investors would be to receive risk spreads, since they seem to pay an elevated reward for bearing economic uncertainty that is augmented by payoffs for the market power of companies.

(more…)

Bad and good beta in FX strategies

June 29, 2019

Bad beta means market exposure that is expensive to hedge. Good beta is market exposure that is cheap to hedge. Distinguishing between these is crucial for FX trading strategies. The market sensitivity of FX positions can be decomposed into a risk premium beta (‘bad beta’) and a real rate beta (‘good beta’). FX positions with risk premium betas are associated with a positive price of risk that increases in crisis periods. FX positions with real rate beta are hedges, whose value increases in crisis times. Many conventional currency trading strategies carry either excessive ‘bad beta’ or too little ‘good beta’ and, thus, fail to produce true investor value.

(more…)

Active fund risk premia in emerging markets

June 22, 2019

Security returns, adjusted for market risk, contain risk premia that compensate for the exposure to active fund risk. The active fund risk premium of a security can be modeled as the product of its beta premium sensitivity and price for exposure to active fund risk. Both components change overtime and mutually reinforce each other in episodes of negative fund returns and asset outflows. This explains why securities with high exposure to active fund risk command high expected returns. Active fund risk premia are particularly prevalent in local EM bond markets, where on average 20% of securities are held by foreign institutional investors, many of which are sensitive to drawdowns. Empirical evidence confirms that bonds whose returns positively correlate with active fund returns command substantial premia. The highest premia and expected returns would be offered at times of large capital outflows.

(more…)

Natural language processing for financial markets

June 15, 2019

News and comments are major drivers for asset prices, maybe more so than conventional price and economic data. Yet it is impossible for any financial professional to read and analyse the vast and growing flow of written information. This is becoming the domain of natural language processing; a technology that supports the quantitative evaluation of humans’ natural language. It delivers textual information in a structured form that makes it usable for financial market analysis. A range of useful tools is now available for extracting and analysing financial news and comments. Examples of application include machine-readable Bloomberg news, news analytics and market sentiment metrics by Refinitiv, and the Federal Reserve communication score by Cuemacro.

(more…)

Market noise

June 1, 2019

The term “market noise” refers to transactions that are erratic and unrelated to fundamental value. Theory suggests that without market noise profitable trading would be impossible. Yet, while irrational and erratic trading may occur, most of what we call “noise” reflects rationality disguised by complexity. Illustrating that point, a new paper shows that the effect of rebalancing cascades on the net demand for individual assets is not predictable, even if we know everything about the underlying rules and if they are fully rational. Predictions become infeasible because of alternating buy and sell orders, feedback loops and threshold-based execution rules. This cautions against dismissing seemingly non-fundamental market flows as irrational and betting against them.

(more…)

U.S. Treasuries: decomposing the yield curve and predicting returns

May 25, 2019

A new paper proposes to decompose the U.S. government bond yield curve by applying a ‘bootstrapping method’ that resamples observed return differences across maturities. The advantage of this method over the classical principal components approach would be greater robustness to misspecification of the underlying factor model. Hence, the method should be suitable for bond return predictions under model uncertainty. Empirical findings based on this method suggest that equity tail risk (options skew) and economic growth surveys are significant predictors of returns of government bonds with shorter maturities.

(more…)

Systematic trading strategies: fooled by live records

May 11, 2019

Allocators to systematic strategies usually trust live records far more than backtests. Given the moral hazard issues of backtesting in the financial industry, this is understandable (view post here). Unfortunately, for many systematic strategies live records can be even more misleading. First, the survivor bias in published live records is worsening as the business has entered the age of mass production. Second, pronounced seasonality is a natural feature of many single-principle trading strategies. This means that even multi-year live records have very wide standard deviations across time depending on the conditions for the strategy principle. If one relies upon a few years’ of live PnL the probability of investing in a losing strategy or discarding a strong long-term value generator is disturbingly high. This suggests that the use of live record as allocation criterion, without sound theoretical reasoning and backtesting, can be highly inefficient.

(more…)

The implicit subsidies behind simple trading rules

April 27, 2019

Implicit subsidies are premia paid by large financial markets participants for reasons other than risk-return optimization (view post here). Their estimation requires skill and a strong “quantamental system”. However, implicit subsidies are behind the popularity and temporary success of many simple trading rules, including those based on variance risk premia, contract hedge value, short volatility bias, and “low-risk effects”. The closest link is between implicit subsidies and cross-asset carry. However, carry is not itself a reliable measure of a subsidy but just correlated with it and – at best – a starting point for estimation The distinction between subsidy and conventional carry is essential for actual long-term value generation of related trading strategies.

(more…)

Implicit subsidies paid in financial markets: updated primer

April 20, 2019

Implicit subsidies in financial markets are premia paid through transactions that have motives other than conventional risk-return optimization. They manifest as expected returns over and above the risk-free rate and conventional risk premia. Implicit subsidies are a bit like fees for the service of compliant positioning. They are opaque rather than openly declared, typically for political reasons. Implicit subsidies have valid motives, such as financial stabilization objectives of governments, profit hedging of commodity producers, or downside protection of institutional portfolios. Detecting and receiving implicit subsidies is challenging and information-intensive but creates stable risk-adjusted value. Implicit subsidies are receivable in all major markets, albeit often at the peril of crowded positioning and recurrent setbacks. It is critical to distinguish strategies based on implicit subsidies, which actually create investor value through information efficiency and those that simply receive non-directional risk premia, which are based on rough proxies and do not create risk-adjusted value.

(more…)

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.

(more…)

Tags

Tags
asset management Asset Purchase Program banks bond returns bond yields bubbles capital regulation carry 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
ABOUT US

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.

FOLLOW US
Linkedin
LEGAL
Research
Quantamental Academy
About Us