Implicit subsidies are premia paid by large financial markets participants for reasons other than risk-return optimization (view post here). Their estimation requires skill and a strong “quantamental system”. However, implicit subsidies are behind the popularity and temporary success of many simple trading rules, including those based on variance risk premia, contract hedge value, short volatility bias, and “low-risk effects”. The closest link is between implicit subsidies and cross-asset carry. However, carry is not itself a reliable measure of a subsidy but just correlated with it and – at best – a starting point for estimation The distinction between subsidy and conventional carry is essential for actual long-term value generation of related trading strategies.

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

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.

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).

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.

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.

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).

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).

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Ralph Sueppel is founder and director of SRSV, a project dedicated to socially responsible macro trading strategies. He has worked in economics and finance for over 25 years for investment banks, the European Central Bank and leading hedge funds. At present, he is head of research and quantitative strategies at Macrosynergy Partners.