We define implicit subsidy as a premium that is paid to financial investors by other market participants through significant transactions or commitments for reasons other than conventional risk-return optimization. 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.

Understanding implicit subsides

The sources of implicit subsidies

Implicit subsidies are premia paid to financial investors indirectly, by means of transactions that are unrelated to conventional optimization of portfolio risk and return. If anyone pays off-market prices or provides liquidity without charge he or she pays a subsidy. Even if a market participant pays a premium for risk it can be a subsidy, as long as that risk does not affect standard portfolio performance measurement. For such payments to translate into subsidies for macro investment, the flows need to be large relative to the market. In practice one can find many of these flows, leading to both premiums paid and discounts demanded:

  • A dominant source of such subsidies are interventions or intervention commitments of governments and central banks for the purpose of economic policy,  rather than risk-return optimization. Such transactions are usually meant to induce private investors to hold particular securities and currencies, by influencing funding conditions, defending price targets, or committing to prevention of market dislocations.
  • Another source are implied elevated insurance premia, such as those paid by suppliers or industrial users of commodities in various future markets for the purpose of hedging price risk or those paid by exporters and importers to for the purpose of hedging exchange rate risk.
  • Issuers of securities with low ratings and volumes (for example EM local currency bonds) often need to pay a premium to investors for poor average liquidity and high liquidity risk (of trading costs rising when the need to trade increases, view post here).
  • Implicit subsidies can also be paid by one group of financial investors to others. Often these arise from different attitudes to mark-to-market volatility.  For example, foreign investors in small and emerging bond markets will often charge a premium on local yields in accordance with 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).
  • 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.

“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

Value proposition and risk

Receiving an implicit subsidy creates value for financial investors because it is payment for the service of bearing risk that matters only or is more relevant for other agents. It is a good value proposition as long as the influence of the subsidy payers is not eclipsed by the flows of subsidy receivers. This type of value generation requires information efficiency  insofar as the financial investor must detect and quantify the subsidy. If the market becomes heavily exposed to a subsidized trade the original subsidy is eroded and the returns on the trade effectively come from a premium for non-directional systematic risk. This would be source of “fake alpha” (view post here).

The 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 not an inherent feature of subsidies, however. It may be absent at times, for example before a subsidy is widely recognized of after “shake-outs” it disappears. Hence, setback risk does not invalidate subsidies as a value proposition but the two should best be viewed in conjunction.

“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 implicit subsidies is the FX carry trade. Historically, positions in floating and convertible currencies with significant 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 to reduce inflation and financial uncertainty. Such policies benefit the risk-return trade-off of lenders in local currency that 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).
  • Second, institutions and households that have experienced or fear financial turmoil are often willing to forgo expected return by holding “hard currencies” rather than carry currencies (view post here). Hence, they are willing to pay an implicit insurance premium. Indeed, FX carry trades have historically been most profitable when high risk premia 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). The arbitrage premium is often another form of implicit subsidy.

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 compressing 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).

An alternative risk premium strategy for currency is based on their hedge value. Depending on circumstances, some currencies can have a tendency to strengthen against the USD, when global or U.S. equity prices fall. Expected negative correlation means that investors pay a premium for holding the currency and an implicit subsidy for those willing to short it. Expected positive correlation means that investors pay a premium for hedging that currency’s risk, which translates into a subsidy for those willing to be long. The hedge value as priced by the market can be inferred directly from quanto index contracts (view post here).

“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

Fixed income carry trades in developed markets often relate to two types of subsidies. The first arises from local refinancing conditions, as set by the central bank. The second is the inflation risk premium paid over and above the expected future short-term funding rates. This premium has historically been paid by the obligor to the creditor, because the dominant issuer of fixed-income securities in most countries is the government sector (largely insensitive to inflation), while the dominant buyers are private households via mutual funds (sensitive to inflation). Importantly, this constellation has changed in recent years due to a continued secular decline in inflation and the surge of government bond holdings at central banks.  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 a premium that is 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 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 can also be embedded in commodity futures curves and particularly the difference between spot and front futures prices. An 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. When futures curves are adjusted for seasonal and expected supply demand effects they often have such indicative value for two reasons:

  • Often commodity futures pay “convenience yields”, which can be interpreted as implied “leasing rates” for the physical commodity. Holding physical inventories increases supply security and flexibility for industrial consumers and thus has enhanced value versus a financial claim. The value of such inventories increases with their scarcity. As a consequence, convenience yields help predicting future demand and price changes (view post here for the crude oil market). 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 are paying volatility risk premia in times of high uncertainty for investors (view post here).

“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 liquid equity markets financial investors are structurally long. The basis for implied subsidies is uncertainty about earnings prospects and about the discount factor for long-term dividend payments. Initial capital owners pay a subsidy for receiving financing and risk sharing. Investors demand some premium for bearing risk and notoriously high volatility. Since 1900 equity investors have been paid a significant premium for that 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. Estimates of this subsidy can be based on the Variance Risk Premium, a premium paid to those bearing the risk of volatility of volatility, measured by the difference between options-implied and realized variance (view post here).

In normal times, however, investors often pay a premium for stocks with higher volatility and market beta. This is because many are constrained in their use of financial leverage: high-volatility stocks given them greater market exposure and higher expected absolute returns. As a consequence, the 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” (forthcoming post).

“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”. Thus, 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 tail risk materializes losses will not symmetrically reduce the manager’s income. More importantly, investment companies often maximize assets-under-management and end 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.

More generally, the price information of volatility markets can be helpful in distinguishing subsidies from price expectations. For example, insurance costs for currency exposure, which is highly relevant for financial and real economic investors, can be inferred from the relation between expected realized and options-implied volatility (volatility risk premium, view post here). More generally, volatility markets are indicative of the price charged by financial markets for both known and unknown risks (view post here). These “insurance costs” can help assessing fear and uncertainty in financial markets and the economy at large.

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

Christopher Cole , 2014