Contents
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. They arise from large transactions or related announcements that are not motivated by conventional portfolio optimization, such as government policy objectives, convenience yields of holding certain assets, non-standard risk aversion, and behavioral biases, such as salience bias and loss aversion. Implicit subsidies are a bit like fees for services that are opaque rather than openly declared. Hence, detecting and receiving implicit subsidies is information-intensive but creates stable risk-adjusted value. Implicit subsidies are receivable in all major markets, albeit 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.
Implicit subsidy here is defined as the expected return of a financial contract over and above the risk-free equilibrium rate and its conventional risk premium in an efficient market. The conventional risk premium arises from the uncertainty of payoffs and the correlation structure of contracts in conjunction with agents’ aversion toward risks. Roughly speaking, a risk premium is the 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 by 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 these standard models depends on the probability distribution of a market portfolio and the risk aversion of a ‘representative investor’.
The implicit subsidy comes about through violations of conventional market efficiency. 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. It is important for the construction of trading strategies. Detecting and receiving implicit subsidies leads to positive expected risk-adjusted returns by conventional metrics. In general, an implicit subsidy can be viewed as a payment for service, typically in the form of positioning in accordance with other private agents’ personal and economic interests or governments’ political interests.
Generally, implicit subsidies result from large-scale transactions or related announcements that are not motivated by conventional optimization of portfolio risk and return. Market flows have the power to drive a wedge between transaction prices and contract value because they consume liquidity and change the market risk assessment of other investors and market makers (view post here). Implicit subsidies can be persistent in the presence of large and repeated flows or standing intervention commitments. Indeed, there are many examples of these:
In equilibrium, a subsidy prevails for as long the market impact of subsidy payers exceeds the market impact of subsidy receivers. If trades and factors related to a subsidy become very popular, the original subsidy is being eroded. In its stead investors simply receive 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). What is worse, even the conventional risk premium can be compressed to or below zero by so-called alternative risk strategies. Unlike implicit subsidies, non-directional risk premia require almost no research and are not a reliable source of value generation. They are just payments for underappreciated risk and embellish conventional portfolio performance statistics.
Indeed, a common drawback of subsidies is that they attract crowds and, like all crowded trades, incur the risk of sudden outsized drawdowns when conditions change. This is a form of “setback risk” or endogenous market risk (view here). Setback risk is changeable. 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. 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 not generally equivalent. Carry is simply the return an investor receives if market prices are unchanged (view post here). Carry is typically cheap in terms of data requirements and easy to calculate. That is why it is popular. It is also true that carry often increases with subsidies and risk premia. However, it 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. In this case carry investors end up paying implicit subsidies to the rest of the market.
The FX carry trade (view post here) is probably the most popular strategy that has benefited from implicit subsidies. On its own, it is not a reliable estimate of expected returns. However, at times (particularly in the 2000s) positions in floating and convertible currencies with significant real carry reaped two types of implicit subsidies.
FX carry opportunities depend on market structure and regulation. In emerging markets observed carry typically contains a combination of classic interest rate differential and an arbitrage premium that reflects the structure, regulation, and pressure points of on-shore and off-shore markets (view post here). This arbitrage premium is also called cross-currency basis. For example, a negative dollar cross-currency basis means that the FX forward implied carry of a currency against the USD is larger than the corresponding on-shore short-term interest rate differential. After the global financial crisis, 2008-09 periods of sizeable dollar cross-currency basis have also been observed in developed markets. They reflect arbitrage frictions due typically to a combination of regulatory restrictions and short-term funding pressure (view post here). In most cases, a negative dollar funding basis increases the implicit subsidy paid by the FX forward market. If synthetic funding rates are higher than on-short interest rate differentials there is a shortfall of the funding currency in offshore markets and an implicit subsidy of those willing to lend via FX swaps (view post here), i.e., selling spot and buying forwards,
FX carry trades also illustrate the inherent vulnerability of subsidy-based investment strategies. Positive carry typically encourages capital inflows into small and emerging markets. This helps to compress inflation but is also conducive to a domestic asset market boom. Because of the former, the central bank does not fight the latter. In this way, FX carry strategies can produce self-validating flows. Financial markets create their own momentum. Conversely, a reversal of such flows is self-destructing (view post here)
To bring trading signals closer to actual subsidies, much can be done to enhance simple carry metrics (view post here). The most plausible additions are adjustments for inflation differentials, consideration of market correlation premia, penalties for poor economic performance (view post here), and external deficits. Also, adjustments for estimated currency over- or undervaluation are conceptually compelling (view post here). Enhanced carry strategies have historically produced much more consistent investor value.
Carry is the most popular but not the only indicator related to implicit subsidies in FX markets. Another approach is estimating the hedge value of currencies. Depending on the circumstances, some currencies tend to strengthen against the USD when global or U.S. equity prices fall. An expected negative correlation with the market portfolio means that investors pay a premium for holding such a currency in a diversified portfolio. This preference translates into an implicit subsidy for those willing to short it on its own. Analogously, the expected positive correlation of a currency with broader market benchmarks means that investors require a discount for holding that currency in a diversified portfolio. This translates into a subsidy for those willing to be long the currency. The hedge value of a currency, as priced by the market, can be inferred directly from “quanto index contracts” (view post here). “Quantos” are derivatives that settle in currencies different from the denomination of the underlying contract.
Implicit subsidies in government bond markets and interest rate swap markets often arise from two sources:
Implicit subsidies in fixed-income markets typically affect real yields (for cash investors) and real carry (for leveraged investors). Real bond yields rise and fall with risk premia and subsidies. They need to be estimated based on some model of inflation expectations. Simple estimates have proven powerful predictors of government bond returns (view post here).
Fixed income carry is a combination of yield spread and curve rolldown. For example, accommodative refinancing conditions in conjunction with inflation concerns lead to steep yield curves, i.e. high carry, at the time when a subsidy is paid. However, as for foreign exchange, fixed income carry is a very rough and imprecise indicator for subsidies. At the very least it must be adjusted for rational short rates expectations, for example by considering the gap between current short-term real rates and their plausible medium-term equilibrium level (view post here).
Risk premia and subsidies for inflation risk have historically been paid by the obligor to the creditor because the dominant issuer of fixed-income securities in most countries has been the public sector, which does not optimize financial risk-return relations. This includes inflation risk premia since governments are insensitive to inflation, while the dominant end investors are private households, which are averse to inflation. Inflation risk premia can vary across time. For example, they were compressed in the era of non-conventional monetary policy (view post here).
A useful indicator for risk premia in fixed-income markets is the duration volatility risk premium, the scaled difference between swaption-implied and realized volatility of swap rates’ changes. Two derived concepts of volatility risk premia hold particular promise for measuring implicit subsidies (view post here). Term spreads are the differences between volatility risk premia for longer-maturity and shorter-maturity IRS contracts and are related to the credibility of a monetary policy regime. Maturity spreads are the differences between volatility risk premia of longer- and shorter-maturity options and should be indicative of a fear of risk escalation.
Generally, obligors with significant credit risk must compensate investors for the implicit option to default. This is not in itself a subsidy but just an option premium. However, obligors sometimes pay premia higher than justified by their actual default probability for the convenience of having stable market access and to compensate investors for research and information cost.
Moreover, smaller and lower-rated obligors typically have to pay a significant “illiquidity risk premium”. This premium compensates investors for tying up their capital for some time and for forfeiting the option of containing losses and adapting positions to changing circumstances. Importantly, there is evidence that this illiquidity risk premium is time-variant and particularly high during and pursuant to periods of market distress (view post here). Hence, taking credit risk in distress times, by distinguishing between actual default risk and excess illiquidity risk premia is a valid strategy for reaping implicit subsidies.
Implicit subsidies are also paid in commodity futures. The futures curve reflects storage and funding costs, supply and demand imbalances, convenience yield, and hedging pressure. Convenience and hedging can give rise to an implicit subsidy, i.e., a non-standard risk premium, and make commodity carry a valid basis for a trading signal (view post here).
Unlike other financial derivatives, storage constraints of the underlying materials obstruct the arbitrage of commodity futures across maturities. The costlier the storage, the greater the barriers and the more volatile the implied carry (view post here). To detect implicit subsidies, futures curves of commodities with high storage costs should be adjusted for predictable supply and demand swings across time, such as seasonal factors (view post here) and temporary gluts or shortages in the underlying. Properly adjusted, a relatively low futures price (“backwardation”) typically indicates a subsidy being paid to the longs in the future. A relatively high futures price (“contango”) may indicate a subsidy being paid to the shorts in the future. There are several sources of such subsidies:
Financial market participants are always net owners of shares in companies. Exposure to equity is undiversifiable risk. The basis for risk premia and implied subsidies is uncertainty about earnings and the discount factor that is applied to them. This uncertainty manifests in high price volatility in share price compared to high-grade fixed-income markets. Moreover, initial capital owners often pay a subsidy for receiving financing and risk sharing. Altogether, since 1900 equity investors have been paid a significant premium for bearing equity price risk: according to a long-term global study real equity returns have been 5% per annum, versus just 1.8% for government bonds and 1% on short-term deposits (view post here).
The equity premium depends on both the actual riskiness of payoffs (determining the quantity of risk) and risk aversion (determining the price of risk). If there was only homogeneous and rational risk aversion the equilibrium premium in equity markets would not be a subsidy. However, it is common that parts of the market develop unusually high or low risk aversion. For example, fear of drawdown rises when portfolio managers are close to loss limits or at the end of an investment period. This fear can give rise to implicit subsidies paid to investors with stable risk aversion.
In normal or quieter times, investors often overpay for stocks with higher volatility and market beta (view post here). This is because many are constrained in their use of financial leverage and high-volatility stocks giving them greater market exposure and higher expected absolute returns. As a consequence, risk-adjusted returns of high-volatility stocks have historically underperformed those of low-volatility stocks, a phenomenon that is called the “low-risk effect” and that can be exploited by leveraged investors in form of “betting against volatility” or “betting against beta” (view post here). There is a whole range of stylized low-risk strategies discussed in financial research that seems to have produced consistently alpha over time (view post here).
Similarly, investors seem to overpay for stocks that have high “emotion betas”, i.e. the emotional “glitter” of stocks, measured as sensitivity to the emotional state of the market (view post here). Empirical research suggests that emotion betas significantly and positively predict subsequent return differentials across stocks. This is backed by theories of emotional utility in investments that imply predictable behavior of investors that covet emotions.
Equity also seems to pay a statistical arbitrage risk premium (view post here). Assets can be hedged against factor exposure through peer assets. The expected return on a hedged position is the arbitrage risk premium, which is estimable, for example, by ‘elastic net’ machine learning. ‘Unique’ stocks have higher excess returns than ‘ubiquitous’ stocks. This is a valid basis for trading strategies.
Option-implied volatilities price implicit subsidies if the market is compromised by “moral hazard”. The direction of the subsidy typically depends on the state of the market.
The price information of volatility markets helps identify subsidies in underlying assets. Generally, volatility markets are indicative of the price charged by financial markets for exposure to both known and unknown risks (view post here).
As mentioned above, the willingness of market participants to pay up for protecting against volatility can be measured by the variance risk premium, the difference between options- or swap-implied volatility, and expected realized return volatility.
The premium paid for such volatility insurance has been a predictor of FX returns (view post here), equity returns, gold futures returns (view post here), and option strategy returns (view post here and here). The directional bias of variance risk premia can be gauged through measures of downside variance premia, the difference between options-implied and actual expected downside variation of returns, and skewness risk premia, the difference between upside and downside variance risk premia (view post here). Over and above the standard variance risk premium, markets also seem to be paying a “volatility of variance premium”. While the former relates to uncertainty about volatility, the latter relates to uncertainty about volatility of volatility, a conceptually and empirically different factor (view post here).
Risk-parity means equal exposure to different investment positions in terms of risk metrics, such as expected return volatility. One of the most successful investment strategies in the 2000s and 2010s has been the risk-parity “long-long” of combined equity, credit and duration derivatives. In a simple form, this trade takes continuous joint equal mark-to-market exposure in equity or credit and duration risk. There have been three apparent contributors to this success: undiversifiable risk premia, implicit subsidies paid by central banks, and great diversification benefits from negative return correlations (view post here).
The macro environment is changeable, however, and a strong theoretical case can be made for managing risk parity strategy based on economic trends and risk-adjusted carry that indicated and predict implicit subsidies. For example, overheating scores, which indicate the withdrawal or enhancement of central bank support, have been strongly correlated with risk parity performance (view post here).
This post is a condensed guide on best practices for developing systematic...
Jupyter Notebook Principal Components Analysis (PCA) is a dimensionality reduction technique that...
Macro-quantamental indicators and trading signals are transformative technologies for asset management. That...
Jupyter Notebook Macro information state changes are point-in-time updates of recorded economic...
Jupyter Notebook Rising inflation is a natural headwind for equity markets in...
Jupyter Notebook of factor calculation Jupyter Notebook of statistical learning There is...
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.