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Implicit subsidies paid in financial markets: updated primer

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.

The below is a partial update of this site’s summary page on implicit subsidies.

From risk premium to implicit subsidy

The conventional risk premium of an individual asset is the expected return over and above the risk-free rate in an efficient financial market equilibrium. An implicit subsidy here is defined as an expected return over and above the risk-free rate and the conventional risk premium in an efficient financial markets equilibrium with frictions, such as heterogeneous agents, government interventions and regulation. The term implicit subsidy is not widely used in financial market theory and is chosen here to clearly distinguish it from conventional compensation for risk. Put differently, detecting and receiving an implicit subsidy produces expected positive risk-adjusted returns by conventional metrics.

Roughly speaking, a risk premium is average expected compensation for bearing uncertainty. Standard asset pricing theory argues that in equilibrium the risk premium paid for holding a capital asset is commensurate to its price sensitivity to overall market value multiplied with the market risk premium. This means that the individual asset’s risk premium increases with its volatility and market correlation. The market risk premium in standard models depends on the probability distribution of a market portfolio and the risk aversion of a ‘representative investor’.

The implicit subsidy is usually paid for bearing specific risk, to which some market participants are particularly averse. This aversion must be over and above the aversion of risk of a representative agent that optimizes financial returns and risk alone. The implicit subsidy can also be paid to dissuade market participants from taking specific risk that some market participants like to reserve for themselves for motives other than return optimization. For example, in low-volatility markets some institutions accept inordinate amounts of risk per unit of expected returns in order to meet volatility or absolute return targets. In general, an implicit subsidy can also be viewed as a payment for service, typically in form of positioning in accordance with other institutions’ or governments’ political interests.

Sources of implicit subsidies

Implicit subsidies arise from large-scale transactions that are unrelated to conventional optimization of portfolio risk and return.  Indeed, there are many examples of these:

  • A common source of implicit subsidies is interventions or intervention commitments of governments and central banks for the purpose of broader economic policy objectives. The classic example is foreign exchange interventions in conjunction with the imposition of significant positive real interest rate differentials relative to a funding currency. This is a plausible and effective strategy against supposed exchange rate misalignment and for the purpose of supporting local price and financial stability (view post here). Through such policies the central bank pays an implicit subsidy for investors that are long the local currency by inducing elevated real local borrowing rates, increasing liquidity in FX spot and forward markets, and reducing volatility in these markets by “leaning against the wind”.
  • Another common implicit macro subsidy is convenience yields, defined as premia for holding the underlying physical product or asset of a derivative. Examples of convenience yields include premia paid by industrial users of certain commodities in the spot market for the availability of physical inventory (view post here) and premia paid by financial institutions for holding low-risk government bonds that can be used as collateral in securitized transactions and that have low regulatory capital charges (view post here).
  • Issuers of securities with low ratings and volumes(for example EM local currency bonds) are often willing to pay extra for market access. Specifically, they typically need to pay a premium to investors for low average market liquidity and high liquidity risk (i.e. the risk of trading costs rising when the need to trade increases, view post here).
  • Even financial investors pay implicit subsidies if they are highly averse to non-standard types of risk. Very few market participants optimize return-risk ratios purely. This is a consequence of cognitive biases and institutional rules.
    For example, a widely documented behavioural bias is that agents exaggerate the probability of extreme events if they are acutely aware of them. This has been labelled “salience theory” (view post here) and implies that many market participants pay over the odds to avoid risk that is clear and present and evidently skewed to the downside.
    Another behavioural bias that induces implicit subsidies is “fear of drawdown”. This refers to traders’ aversion to large protracted losses. This fear is the dominant factor in risk perceptions according to experimental research, more so than volatility. Institutional investors have reason to avoid showing outright losses at the end of reporting periods and professional traders are constrained by so-called “drawdown limits”. As a result, both will pay over the odds to shed or protect positions that might lead them into these dreaded depths. Conversely, investors who are willing to endure protracted drawdowns that are due to biased positioning are paid subsidies, maybe in form of fire sale prices, and can reap disproportionately higher volatility-adjusted returns in the long run (view post here). This sometimes benefits specialized “distressed funds”. Indeed, variance swap data suggest that investors pay elevated premia to hedge against price variance after a market price drops(view post here). This is consistent with the hypothesis that many portfolio managers are willing to pay implicit subsidies in order to contain mark-to-market drawdowns that can result in loss of assets-under-management or position.
  • Many market participants can be distraught by mark-to-market volatility and are – at times – willing to pay over the odds to reduce it.
    Indeed, popular risk perceptions and risk aversion are changing overtime, often following the moves in financial markets and the focus of popular media. Changing attitudes towards risk translate into changing equity premia and there is evidence that this makes equity return trends predictable (view post here). From the perspective of investors with low or stable risk aversion such premia can be estimated and received when sufficiently high. There is a broad range of market risk perception measures available for this purpose (view post here).
    Aversion to volatility also can be an institutional feature. Thus, foreign investors in small and emerging bond markets will often charge a premium on local yields in accordance to exchange rate risk and volatility, simply because they account in USD and have only limited hedging capacity. In times of unusually high FX volatility, this translates into elevated premia (subsidies) for local rates receiver positions (view post here).

Value proposition and risk of implicit subsidies

Receiving an implicit subsidy creates value for a financial investor because he or she is overpaid for bearing a specific type of risk relative by the standards of his or her own aversion. The value proposition holds as long as the market impact of payers of such subsidies exceeds the market impact of receivers of such subsidies. If many market participants engage in a subsidized trade, however, the original subsidy disappears. In its stead then arises a conventional risk premium for engaging in a crowded trade. This is a premium for non-directional systematic risk and a source of “fake alpha” (view post here), which is often propagated and compressed to or below zero by so-called algorithmic alternative risk strategies. Unlike implicit subsidies, non-directional risk premia require almost no research or information efficiency and are not a reliable source of value generation. They just receive a more or less fair premium for a risk that is not fully appreciated by conventional investment statistics.

Indeed a common drawback of subsidies is that they often attract crowds and, like all crowded trades, incur the risk of sudden outsized drawdowns when conditions change. This “setback risk” is dealt with in a separate section (view here). Setback risk is changeable, however. It is usually low before a subsidy is widely recognized or after “shake-outs”. It is usually high when a subsidy-induced trade is touted by brokers or even popular media. Hence, setback risk does not generally invalidate subsidies as a value proposition. However, its consideration is complementary to strategies based on implicit subsidies.

Strategies that reap implicit subsidies are sometimes correlated with carry strategies, but they are never the same. Implicit subsidies are different from carry because carry is simply the return an investor receives if market prices are unchanged. Carry is easy to calculate and indeed often increases with subsidies and risk premia (view post here). However, carry is at best a very crude measure for implicit subsidies, lacking in precision and robustness. In the worst case carry can become negatively related to implicit subsidies, if crowds of investors use it for positioning without considering the actual risk-return trade-off, thereby paying implicit subsidies to the rest of the market.


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