Implicit subsidies

Understanding implicit subsides

From risk premium to implicit subsidy

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.

The sources of implicit subsidies

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:

• A common source of implicit subsidies is interventions or intervention commitments of governments and central banks for the purpose of macroeconomic policy objectives. The prime example is foreign exchange interventions in conjunction with the imposition of positive real interest rate differentials relative to funding currencies. This policy is often used to tackle supposed exchange rate misalignment and to support local price and financial stability (view post here). It represents an implicit subsidy because international investors receive elevated real rates on local deposits, better liquidity in FX spot and forward markets, and reduced return volatility due to central banks’ “leaning against the wind”.
  Many economists also suggest that central banks have generally subsidized developed equity, bonds, and credit markets over the past two decades through setting highly accommodative refinancing conditions and systematic direct intervention in asset markets, particularly in times of financial distress (central bank ‘put’). This subsidy has benefited particularly the ‘risk parity long-long trade’, balanced risk exposure to both bond and equity markets, one of the most successful simple trading strategies in the 2000s and 2010s (view post here).
• 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 in certain commodity spot markets 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 incur low regulatory capital charges (view post here). Interestingly, it is not only the convenience itself that may indicate an implicit subsidy but also the risk around it. In the commodity space convenience yield risk estimates have positively predicted future commodity future returns (view post here).
• Some agents pay up for reputation and the benefit of ongoing involvement in the market. For example, issuers of securities with low ratings and volumes, such as 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 purely according to textbook models. The price of risk can be heavily influenced by cognitive biases and institutional rules.
  For example, a widely documented behavioral bias is that agents exaggerate the probability of extreme events if they are acutely aware of them. This has been labeled “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 behavioral bias that induces implicit subsidies is “fear of drawdown”, i.e. aversion to large protracted losses. According to experimental research, this fear is more prevalent in risk perceptions than dislike of volatility. Also, 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 past these barriers. 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).
  Also, financial regulation and accounting rules can encourage institutional investors to pay subsidies. 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 (view post here), i.e. a widening gap between expected returns of assets with volatile prices and so-called risk-free short-term fixed income assets.
• Behavioral theory and experimental evidence suggest that irrational decision-making along the lines of “prospect theory” gives a more realistic description of investor actions than standard utility maximization. Indeed, “prospect theory value”, based on the past return distribution of an asset, is a valid investment factor, particularly when market efficiency is compromised (view post here).
  For example, private investors are more sensitive to losses than to gains, a phenomenon called “loss aversion” (view post here). Loss aversion manifests, for example, in the risk reversal premium, i.e. overpricing of out-of-the-money put options relative to equivalent out-of-the-money call options (view post here). Loss aversion also implies that risk aversion is changing with market prices. This means that the compensation an investor requires for holding a risky asset varies over time. 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).
• Many institutions also overcharge for volatility risk for reputational reasons. 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 over time 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.

The risks of trading implicit subsidies

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.

Popular strategies based on implicit subsidies

Foreign exchange

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.

• Government support: central banks often set high real local short-term interest rates and engage in FX interventions to reduce inflation and attract capital flows. Such policies improve the risk-return trade-off of agents that lend locally and fund in foreign currency. Empirical research shows that official currency interventions can cause persistent external imbalances and over- or under-valuation of currencies (view post here) as a consequence of the portfolio balance effect. Moreover, central banks that lean against the wind of carry flows through sterilized currency interventions create an FX forward bias, i.e. a state where expected currency changes compound interest differentials rather than offset them (view post here). Suppressed valuation and forward bias imply subsidies to the market.
• Private insurance premia: when local currency depreciation is a clear and present concern corporates, banks and households often prefer holding funding currencies to protect their business and mere subsistence. For example, financial institutions hold precautionary positions in U.S. dollar assets as protection against funding pressure (view post here). This gives rise to a safety premium on the dollar. Also, in EM economies companies often buy dollars in crisis periods to secure liquidity for international transactions. Accepting negative expected returns in such situations is like paying insurance premia. Indeed, FX carry trades have historically been most profitable when fear of disaster triggered 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 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.

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. The most plausible additions are adjustments for inflation differentials, consideration of market correlation premia, and penalties for poor economic performance and external deficits. Enhanced carry strategies have historically produced much more consistent investor value (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 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.

Fixed income

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

• Funding conditions: Central banks steer refinancing conditions in accordance with inflation targets 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.
• Convenience yields: Fixed income securities are commonly used 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).

The above creates links between subsidies and fixed income carry, with the latter being 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, 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 the growing importance of central banks as government bondholders.  As a result, inflation compensation and risk premia appear to have decreased markedly (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.

Credit

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.

Commodity futures

Implicit subsidies also show in commodity futures curves. 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). In order 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:

• Often industrial users of commodities pay “convenience yields” for materials they like to have in store. This is a cause of backwardation and can be interpreted as implied “leasing rates” for physical commodity on-premise. 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 on 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. It is harder to find convenience providers in times of financial distress.
• Both producers and consumers of commodities are often willing to pay a premium for hedging future demand or supply,a tendency that was formulated in the “hedging pressure theory” (view post here). 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 backwardation and positive carry (for theory and evidence view post here).
• There is also evidence that some commodity futures pay variance risk premia, i.e. high option implied volatilities relative to expected actual return volatility, 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 overpay for such protection. Their role in commodity markets has increased markedly since the 2000s.

Equity

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.

• 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. The variance risk premium is 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, subsidies may be estimated based on the premium charged for the uncertainty of the correlation of securities among each other or with a market benchmark. This is called correlation risk premium and arises from the common experience that correlation surges 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 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.

Volatility markets

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.

• 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 the reputation of managers are threatened by violations of risk limits and maximum drawdown limits.

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.

• Historically, the variance risk premium has been positive in the long run and fairly consistently so (view post here). It compensates investors for taking short volatility risk. A short volatility position typically produces a positive correlation with the equity market and occasional outsized drawdowns.
• For short-term trading strategies, the variance risk premium can be estimated in a timely and realistic manner by choosing an appropriate lookback horizon and considering the mean-reverting tendency of volatility (view post here).

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

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).