Implicit subsidies

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 services. 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 for portfolios. 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.

Understanding implicit subsides

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 return 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 the form of positioning in accordance with other institutions’ or governments’ political interests.

“Quantifying the implicit subsidy to banks has generated considerable interest over recent years. The numbers are striking, both in their sheer scale, but also in their variation.”

Bank of England, 2012

The 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”.
    Central bank also seem to have subsidized the large developed equity, bonds and credit markets over the past two decades through setting highly accomodative refinancing conditions and systematic direct intervention is asset markets, particularly in times of financial distress (cental bank ‘put’). This subsidy has been reaped by the ‘risk parity long-long trade’, one of the most successful simple trading strategies in the 2000s and 2010s (forthcoming post).
  • 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 according to textbook models. The price of risk can be heavily influenced by 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.
    Institutional causes of non-rational risk premia include financial regulation and accounting rules. For example, increased capital requirements for mark-to-market risk on the balance sheets of banks and insurance companies after the great financial crisis have apparently contributed to rising risk spreads (forthcoming post), i.e. a widening gap between expected returns of assets with volatile prices and so-called risk free short-term fixed income assets.
  • 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). More generally, EM bond markets seem to contain active fund risk premia. The active fund risk premium of a security would be the product of its beta premium sensitivity and price for exposure to active fund risk (view post here). 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. From the perspective of an investor with stable risk aversion, the highest subsidies would be receivable in bonds that are popular longs or overweights and in times of capital outflows.

Value proposition and risk

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.

“While there may well be more diversity in the types of strategies hedge funds follow, there is also considerable clustering, which raises the prospect of larger moves in some markets if conditions lead to a general withdrawal from these ‘crowded’ trades.”

Timothy Geithner, 2004

Popular strategies based on implicit subsidies

Foreign exchange

One of the most popular strategies related to implicit subsidies is the FX carry trade. On its own, it is not a very precise and reliable estimate of expected returns but only a starting point for good systematic strategies. However, at times (particularly in the 2000s) positions in floating and convertible currencies with significant real interest rate differential to the USD have benefited from two types of implicit subsidies.

  • First, central banks often impose high real local short-term interest rates and engage in FX interventions, in both directions, to reduce inflation and financial uncertainty. Such policies benefit the risk-return trade-off of agents that lend in local currency and fund in foreign currency. Empirical research shows that official currency interventions can cause persistent external imbalances and over- or under-valuation of a currency (view post here). Moreover, central banks that lean against the wind of carry flows through sterilized currency interventions create what is called an “FX forward bias”, a combination of interest differential and expected currency appreciation (view post here). Suppressed valuation and forward bias offer implicit subsidies to the market as a whole.
  • Second, corporates and households that are fearful of financial turmoil often prefer holding ‘hard currencies’ or ‘funding currencies’ rather than ‘carry currencies’ in order to contain downside risk for business or to preserve subsistence. For example, in EM economies companies often buy dollars in crisis periods to secure liquidity for international transactions. Forgoing expected returns in such situations is similar to paying insurance premia. Indeed, FX carry trades have historically been most profitable when fear of disaster caused both high interest rates and undervaluation (view post here). Likewise, there is evidence that high risk aversion as measured by volatility risk premia, differences between options-implied and actual volatility, leads to undershooting and subsequent outperformance of carry currencies (view post here).

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 state 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. Since 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.

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 and 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).

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 circumstances, some currencies have a tendency to strengthen against the USD when global or U.S. equity prices fall. An expected negative correlation 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 equity prices means that investors require a discount for holding that currency in a diversified portfolio, which translates into a subsidy for those willing to be long. 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.

“Suppose that a country is temporarily risky: it has high interest rates, and its exchange rate is depreciated. As its riskiness reverts to the mean, its exchange rate appreciates.”

Farhi and Gabaix, 2004

Fixed income

Implicit subsidies in government bond and interest rate swap markets often arise from two sources.

  • Central banks steer refinancing conditions in accordance with price and financial stability objectives. With the rise of non-conventional monetary policy central banks have become able to exert influence through a wide array of instruments, including short-term refinancing rates, longer-dated repurchase agreements, asset purchase programs and collateral policies.
  • There is ample deployment of fixed income securities for purposes other than risk-return optimization. Common examples include liability hedging (for pension funds and insurance companies) and collateralization of secured transactions. The latter would imply that some high-grade bonds have value beyond return. U.S. government bonds, in particular, seem to provide a sizable consistent convenience yield that tends to soar in crises (view post here).

This creates a link between subsidies and fixed income carry. 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, is largely insensitive to inflation, while the dominant end investors are private households, which are averse to inflation. Importantly, bond investors’ aversion to inflation risk has been reduced in recent years by a  secular decline in inflation and growing importance of central banks as government bondholders.  As a result, inflation compensation and risk premia appear to have decreased markedly (view post here).

“Due to the risk of changes in inflation, inflation compensation generally contains an inflation risk premium.”

International Journal of Central Banking, 2015

Credit

Generally, obligors with significant credit risk have to 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 circumstance. 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 based on implicit subsidies.

“When an investor accepts illiquidity, it accepts an increase in the uncertainty of end outcome because it is less able to liquidate the asset should something not turn out as expected. Even if the asset can be liquidated, its illiquidity manifests in lower certainty over the price.”

Willis Towers Watson paper, 2016

Commodity futures

Implicit subsidies also affect commodity futures curves. Unlike other markets, commodity futures curves are segmented by obstacles to intertemporal arbitrage. The costlier the storage, the greater is the segmentation and the variability of carry (view post here). In order to extract premia and implicit subsides commodity futures curves should be adjusted for seasonal factors (view post here) and other expected supply-demand effects. Properly adjusted, a relatively low futures price (“backwardation”) may indicate a subsidy being offered to futures holders, analogously to positive carry in FX. A relatively high futures price (“contango”) may indicate a subsidy being demanded from futures holders, analogously to a negative carry. There are several sources of such subsidies:

  • Often industrial users of commodities pay “convenience yields”, which can be interpreted as implied “leasing rates” for the physical commodity. Holding physical inventories increases supply security and flexibility for production and thus provides benefits over and above financial return. The value of such inventories increases with their scarcity. Convenience yields are the basis of a rational asset pricing model for commodities (view post here) and help to predict future demand and price changes (view post here). Importantly, the effective premium paid through the convenience yield depends upon risk factors in other asset markets (view post here). Due to the “financialization” of commodities, there will often be a link between investors’ willingness to hold convenience claims and their risk exposure in bond, equity, and other financial markets.
  • Producers and consumers of commodities are also often willing to pay a premium for hedging future demand or supply (“hedging pressure theory”). For example, in markets where the balance of hedging is on the producer side, future supply may be sold with a discount, by itself leading to a “backwardated” futures curve and positive carry (for theory and evidence view post here).
  • There is also evidence that some commodity futures pay variance risk premia in times of high uncertainty for investors (view post here). This premium can be thought of as the compensation demanded by financial investors for changes in volatility (see below). Financial investors with strict risk management procedures tend to pay over the odds for such protection. Their role in commodity markets has increased markedly since the 2000s.

“Convenience yield can be thought of as the interest rate paid in barrels of oil for borrowing one barrel of oil.”

Bank of Canada, Working Paper, 2014

Equity

In equity markets financial investors are structurally long. The basis for both risk premia and implied subsidies is uncertainty about earnings prospects and about the discount factor for long-term dividend payments. This uncertainty manifests in high price volatility in share prices, compared to the standards in cash fixed income markets. Moreover, initial capital owners often pay a subsidy for receiving financing and risk sharing. 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).

When risk aversion (as opposed to actual riskiness of assets) is high a part of equity investors are willing to sacrifice risk-adjusted returns in order to avoid exposure to the “pain” of experiencing large mark-to-market drawdowns and outsized volatility that violates formal risk metrics. This translates into an implicit subsidy to investors with stable risk aversion. Estimates of this subsidy can be based on the variance risk premium (or volatility risk premium), a premium paid to those bearing the risk of volatility of volatility, often measured by the difference between options-implied and expected realized variance (view post here) or the difference between variance swap rates and expected realized variance (view post here). Analogously, a premium is charged for the uncertainty of correlation of securities among each other or with a market benchmark. This is called correlation risk premium and arises from the common experience that correlations surge and diversification decreases in market crises, summarized in the adage that in a crash ‘all correlations go to one’ (view post here). Correlation risk premia can be estimated based on option prices and their implied correlation across stocks.

In normal times, however, investors often pay a premium for stocks with higher volatility and market beta. This is because many investors are constrained in their use of financial leverage: high-volatility stocks given 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).

“The equity risk premium is the extra return that investors demand over and above a risk free rate to invest in equities as a class. Thus, it is a receptacle for investor hopes and fears, with the number rising when the fear quotient dominates the hope quotient.”

Aswath Damodaran , 2013

Volatility markets

Option-implied volatilities can price implicit subsidies if the market is compromised by “moral hazard”. There are two common examples:

  • Portfolio managers that receive annual performance fees have an incentive to “sell tail risk”, which will enhance their conventional risk-adjusted returns. On the rare occasion that such tail risk materializes the resulting losses will not symmetrically reduce the manager’s income. More importantly, investment companies often maximize assets-under-management and their investors allocate to funds with better recent performance. This creates a bias for portfolios with steady above-par payouts (or steady above-par expected mark-to-market gains) in exchange for elevated explicit or implicit tail risks (view post here). The bias tends to be strongest in “good times” when competition for fund inflows is high. It leads to discounted insurance premia for option-implied financial risk that can be measured and gainfully used for long-volatility and tail risk strategies.
  • In turbulent times, institutional investors have an incentive to pay excessive premia to contain volatility risk, as assets, jobs, and reputation of managers are threatened by violations of risk limits and maximum drawdown limits.

Moreover, the price information of volatility markets can be helpful for identifying subsidies in underlying assets. Generally, volatility markets are indicative of the price charged by financial markets for 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/swap-implied volatility and expected realized return volatility. Such a premium can be estimated in a timely and realistic manner by choosing an appropriate lookback horizon and considering the mean-reverting tendency of volatility (forthcoming post). 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).

“Volatility trading is about putting a price on known unknowns and unknown unknowns.”

Christopher Cole , 2014