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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Seasonal effects in commodity futures curves

July 7, 2018

Seasonal fluctuations are evident for many commodity prices. However, their exact size can be quite uncertain. Hence, seasons affect commodity futures curves in two ways. First, they bias the expected futures price of a specific expiry month relative that of other months. Second, their uncertainty is an independent source of risk that affects the overall risk premia priced into the curve. Integrating seasonal factor uncertainty into an affine (linear) term structure model of commodity futures allows more realistic and granular estimates of various risk premia or ‘cost-of-carry factors’. This can serve as basis for investors to decide whether to receive or pay the risk premia implied in the future curve.

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Term premia and macro factors

June 30, 2018

The fixed income term premium is the difference between the yield of a longer-maturity bond and the average expected risk-free short-term rate for that maturity. Abstractly, it is a price for commitment. The term premium is not directly observable but needs to be estimated based on the assumptions of a term structure model that separates expected short-term rates and risk premia. Model assumptions become a lot more realistic if one includes macroeconomic variables. In particular, long-term inflation expectations plausibly shape the long-term trend in yield levels. Also cyclical fluctuations in inflation and unemployment explain slope and curvature to some extent. A recent IMF paper proposes a methodology for integrating macroeconomic variables in a conventional affine term structure model.

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VIX term structure as a trading signal

June 23, 2018

The VIX futures curve reflects expectations of future implied volatility of S&P500 index options. The slope of the curve is indicative of expected volatility and uncertainty relative to volatility and uncertainty priced in the market at present. Loosely speaking, a steeply upward sloped VIX futures curve should be indicative of present market complacency, while an inverted downward sloped curve should be indicative of present market panic and capitulation. In both cases the slope of the curve would serve as a contrarian indicator for market directional positions. An empirical analysis for 2010-2017 suggests that an inverted VIX curves has had a significant positive relation with subsequent S&P500 returns. Normal VIX curves, however, did not have significant predictive power, possibly because a market can stay complacent longer than it can panic.

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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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A simple rule for exchange rate trends

June 2, 2018

Over the past decades developed market exchange rates have displayed two important regularities. First, real exchange rates (nominal exchange rates adjusted for domestic price trends) have been mean reverting. Second, the mean reversion has predominantly come in form of nominal exchange rate trends. Hence, a simple rule of thumb for exchange rate trends can be based on the expected re-alignment the real exchange rates with long-term averages over 2-5 years. According to a new paper, FX trend forecasting models based on this rule outperform both the random walk and more complex forecasting models.

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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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Using yield curve information for FX trading

May 12, 2018

FX carry trading strategies only use short-term interest rates (and forward basis) as signal. Yet both theoretical and empirical research suggests that the whole relative yield curve contains important information on monetary policy and risk premia. In particular, the curvature of a yield curve indicates – to some extent – the speed of adjustment of the short rate towards a longer-term yield. Since relative curvature between two countries is therefore a measure of the relative trajectory of monetary policy it is a valid directional signal for FX trading. Indeed, recent empirical research suggests that this signal is statistically significant. A curvature-based trading rule produces higher Sharpe ratios and less negative skewness than conventional FX carry strategies.

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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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