Implicit subsidies

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.

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 that is complicated by 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 this type of expected return 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’.

Implicit subsidy is expected excess compensation for bearing specific risk, to which some market participants are particular averse. This aversion must be over and above the aversion of risk of a representative agent that optimizes financial returns and risk alone. Therefore, 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.

“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 rise from large-scale transactions that are unrelated to conventional optimization of portfolio risk and return. If a large market participant 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, if the risk he seeks to insure against is beyond the risk aversion of a standard representative financial investor. For such payments to translate into subsidies for macro investment, the flows need to be a significant share of the overall market. Indeed, in practice one can find many of these flows, leading to both premiums paid and discounts demanded:

  • A common source of such subsidies is interventions or intervention commitments of governments and central banksfor the purpose of economic policy. The classic example is foreign exchange interventions that provide extra liquidity and volatility reduction (view post here). These flows 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 of implicit subsidies is elevated insurance premia paid by non-financial private agents. This includes excess risk premia paid by suppliers or industrial users of commodities in various future markets for price and planning certianty, excess premia paid by consumers of commodities in the spot market for availability of physical inventory (view post here), or excess premia paid by exporters and importers in foreign exchange markets 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 (i.e. the risk of trading costs rising when the need to trade increases, view post here).
  • Implicit subsidies are even paid by financial investors that are particularly averse to specific types of risk. For example, fear of drawdown, i.e. of large protracted losses, is the dominant factor in risk perceptions according to experimental research, more so than volatility. Institutional investors, in particular, have strong aversion towards showing outright losses at the end of reporting periods. As a result, investors who are willing to accept such protracted drawdowns can reap disproportionately higher volatility-adjusted returns (view post here). Some investors also occasionally pay over the odds to contain mark-to-market volatility.  For example, 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, variance swap data suggest that investors pay elevated premia to hedge against price variance after market price drops (view post here). This is consistent with the hypothesis that many portfolio managers are willing to pay over the odds in order to contain mark-to-market drawdowns that can result in loss of assets or position.
  • Both private and institutional investors are uncomfortable with the high uncertainty that market turbulences bring. Hence, they are willing to pay excess premia to mitigate uncertainty in such times. Put differently, 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).

Value proposition and risk

Receiving an implicit subsidy creates value for financial investors because the financial investor is overpaid for the service of bearing a specific type of risk, relative to his or her own aversion. The value propositions 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 arises a conventional risk premium for engaging in a crowed trade. This is a premium for non-directional systematic risk and a source of “fake alpha” (view post here). Failure to distinguish implicit subsides from fake alpha breeds ignorance as to whether a specific trade or strategy actually produces investor value.

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 not stable, 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 subsides.

Strategies that reap implicit subsidies are related to carry strategies, but they are not 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.

“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. 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, 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. Both actions favor the carry trade and represent a subsidy to the market as a whole (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).

Another implicit subsidy arises from 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. 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, 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).

“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 are motivated by two types of subsidies. The first arises from refinancing conditions set by the central bank. The second type arises from risk premia for uncertainty of future real interest rates and inflation, which drive a wedge between expected short rates and long-yield implied short rates. Both easy short-term funding conditions and high risk risk premia give rise to a steep yield curve and high fixed income carry. However, fixed income carry also contains expectations for future short-term interest rates. To use fixed income as a conceptually plausible trading signal subsidies must be separated from the effect of 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).

The inflation risk premium has 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 is largely insensitive to inflation, while the dominant end investors are private households, which are sensitive to inflation. Importantly, bond investors’ aversion to inflation risk has been reduced in recent years by a  secular decline in inflation and a growing importance of central banks as government bond holders.  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 also affect commodity futures curves, particularly the difference between spot and front futures prices. For futures curves to have indicative value they 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 has enhanced value versus a financial claim. 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 predicting 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 are paying 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 liquid 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. 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 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 realized variance (view post here). Analogously, a premium is charged for 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 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” (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 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 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 indentifying 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-implied and actual expected 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). 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