RP Market Watch - RaisePartner Raise Partner - Robust Risk Management, Advanced Solutions for Quantitative Finance http://www.raisepartner.com/rep-edito.html 30 <![CDATA[RaisePartner joins the EDM Council]]> http://www.raisepartner.com/rep-edito/ido-79/raisepartner_joins_the_edm_council.html Tue, 24 Jan 2012 14:24:00 <![CDATA[Explaining systemic risk]]> http://www.raisepartner.com/rep-edito/ido-78/explaining_systemic_risk.html During the Systemic Risk and Data Issues conference held in Washington last week, we had the opportunity to hear the economist Anton Korinek* present a crystal-clear model of systemic risk based on financial amplifications**:

1. Banks raise finance from households and invest in risky projects (assets).

2. In times of crisis (economic shock), the returns of these risky assets are low.

3. Contracted debts and tightening financial constraints force them to sell their assets at a low price (&ldquo;fire sales&rdquo;).

4. This triggers financial amplification effects: the more banks sell, the larger the decline in asset prices; as a consequence, banks need to sell even more assets to raise enough liquidity and meet a given repayment obligation.

These financial amplifications are characteristic of systemic risk:





References

* Anton Korinek (http://www.korinek.com/) has been an assistant professor of economics at the University of Maryland since 2007, after receiving his PhD from Columbia University. His research focuses on international finance and macroeconomics, with special emphasis on financial crises.

** Anton Korinek , « Systemic Risk-Taking: Amplification Effects, Externalities, and Regulatory Responses », Feb 2011.]]> Mon, 10 Oct 2011 12:42:00 <![CDATA[Conference on Systemic Risk and Data Issues]]> http://www.raisepartner.com/rep-edito/ido-77/conference_on_systemic_risk_and_data_issues.html RaisePartner is attending the Conference on Systemic Risk and Data Issues in Washington on October 5th and 6th 2011.

This conference is being organized in the context of the Dodd-Frank Act and the establishment of new entities, among which the Financial Stability Oversight Council (FSOC) and Office of Financial Research (OFR).

The main purpose of the conference is to bring together participants from academia, regulatory agencies, government and financial industry for an exchange of views based on presentations of research/policy papers and regulatory panels.]]> Thu, 06 Oct 2011 09:50:00 <![CDATA[Early signs of market stabilization?]]> http://www.raisepartner.com/rep-edito/ido-76/early_signs_of_market_stabilization_.html
After a large bump mid-August, the RP Quant Systemic Risk Index continued to rise at a slower pace early September and reached its highest value mid-September (243). However, the index has started to slowly decrease over the past week (230 on September 23rd).

The examination of the correlation map we introduced last week shows that the &ldquo;red wave&rdquo; has stopped its progression: after stabilizing at a very high level (>84%) for a few weeks, correlations between the industrial sectors seem to slowly decrease but remain larger than 82%.

But caution still applies as the systemic risk level remains very high. Last week, president of the AMF (Autorité des marchés financiers) Jean-Pierre Jouyet mentioned a « very worrying situation on the financial markets » and a « risk of systemic crisis » that might lead to a worldwide recession (source: REUTERS). &ldquo;The situation is not better than it was in 2008&rdquo;, he said. Indeed, the RP Quant Systemic Risk Index reached a value of 210 in October 2008, which is lower than today's level (230).

For more information and analysis, visit the new section of our website dedicated to the RP Quant Systemic Risk Index.]]> Tue, 27 Sep 2011 11:11:00 <![CDATA[Red alert on cross-sector correlations confirmed]]> http://www.raisepartner.com/rep-edito/ido-75/red_alert_on_cross_sector_correlations_confirmed.html
An in-depth analysis of the cross-sector correlations underlines the extreme sensitivity of today's market conditions: a chock on any industrial sector is instantly propagated to the other sectors.

The risk alert pointed out by the RP Quant Systemic Risk Index last week is confirmed as the index continues to rise this week, remaining above its 2008 level:




To illustrate the meaning of this aggregated risk indicator, let's look at the correlations between the industrial sectors of the Dow Jones Index and their evolution since 2006.

The surface charts below show the cross-sector correlation matrix* at 3 different dates: in the pre-2007 market conditions, at the heart of the 2008 crisis and today.

Each color stands for a given level of correlation (from blue = negatively correlated to red = highly positively correlated):



Chart 1. In standard market conditions, the cross-sector correlations range approximatively from -50% to 90%, with most values between 0% to 50% (green and yellow zones).

Chart 2. During the subprime crisis, the industrial sectors became highly dependent, with correlations ranging from 62% (orange zones) to 95% (red zones).

Chart 3. During the past few weeks, the cross-sector correlations reached a new high with a minimum value of 84%; most of the correlations are above 90% as illustrated by the dominant red zone.


Analyzing the dynamics of the cross-sector correlations confirms the unique nature of today's market regime, hence the need for investors and risk managers to define reactive systemic risk alerts.


* The DJ industrial sectors represented in the correlation matrices are the following: Basic Materials, Consumer Goods, Consumer Services, Finances, Health Care, Industries, Oil & Gas, Technology, Telecommunications, Utilities.]]> Wed, 14 Sep 2011 12:58:00 <![CDATA[Le risque systémique atteint un niveau sans précédent]]> http://www.raisepartner.com/rep-edito/ido-74/le_risque_systemique_atteint_un_niveau_sans_precedent.html
Inquiétudes vis-à-vis de la fragilité des marchés financiers

R. Zoellick, le président de la Banque Mondiale, déclarait le 6 Septembre : « Nous entrons dans une période dangereuse. Tandis que les Etats-Unis semblent éviter une nouvelle récession grâce à une croissance lente, la zone Euro se retrouve face à une situation particulièrement délicate. » (source : Bloomberg [1])

Les observations quantitatives appuient-elles les inquiétudes formulées ces derniers mois ?

Le niveau d'interdépendance entre les secteurs industriels: un indicateur pertinent de la fragilité des marchés et du risque systémique

La capacité des acteurs du marché à analyser la situation économique réelle des entreprises cotées est l'un des indicateurs de la stabilité des marchés financiers.

Les différents secteurs industriels n'ont pas les mêmes caractéristiques fondamentales (taille du marché, équilibre de l'offre et de la demande,...). Ces spécificités impliquent un certain niveau d'indépendance (ou décorrélation) entre les indices sectoriels lorsque les marchés financiers ont un comportement normal, c'est-à-dire lorsque les marchés sont en phase avec les fondamentaux de l'économie réelle.

Par contre, lorsque le risque systémique est élevé, les acteurs du marché sont influencés par des facteurs tels que la liquidité et les secteurs ont tendance à se corréler fortement.


Le risque systémique à un niveau sans précédent

L'observation de ces corrélations inter-sectorielles via un indicateur agrégé révèle une sensibilité des marchés encore plus forte qu'en 2008.

L'indice RP Quant Systemic Risk, un indicateur agrégé quotidien du niveau d'interdépendance entre les secteurs industriels du Dow Jones, a atteint cette semaine un niveau encore plus élevé qu'à la fin de l'année 2008 (220 en août dernier contre 210 en 2008) :




La hausse soudaine de l'indice s'explique par le fait que les corrélations entre les secteurs industriels ont pour la plupart franchi la barre des 90% ces dernières semaines !

En observant l'évolution de l'indice RP Quant Systemic Risk, on constate que les marchés financiers ne sont jamais revenus à leur état « normal » (celui d'avant 2007) depuis la crise de 2008 puisque l'indice n'est pas repassé sous la barre des 100 depuis. Si les mesures d'urgence d'injection de liquidité ont permis d'éviter à la machine de se gripper, elles n'ont pas pour autant assaini la situation de fonds des marchés.

L'indice de volatilité implicite des marchés (VIX), indicateur instantané de l'aversion au risque, n'a quant à lui toujours pas atteint son niveau record de 2008. Dans le contexte actuel de marchés «à fleur de peau», on peut cependant s'attendre à une forte hausse de la volatilité si les leaders Européens ne convergent pas rapidement vers un accord concret.

Ces observations quantitatives vont dans le sens des inquiétudes exprimées par l'ensemble des acteurs et soulignent la nécessité d'avancer vers ce que Lord Gladwyn appelait «la nécessité de l'intégration politique européenne» (source : [2]).


Méthode de construction de l'indice

L'indice RP Quant Systemic Risk est un indicateur agrégé des corrélations entre les 10 secteurs industriels du Dow-Jones: Matériaux de base, Biens de consommation, Services aux consommateurs, Finances, Santé, Industries, Pétrole et Gaz, Technologie, Télécommunications, Producteurs de Pétrole et de Gaz.

L'indice est calculé de manière quotidienne selon la formule suivante:





où la dynamique des corrélations inter-sectorielles &rho;_ij (t) est estimée par un modèle de risque propriétaire basé sur des technique adaptative dans la lignée des résultats de Spokoiny and Mercurio (source: [3]).

Read the english version

Réferences

[1] http://www.bloomberg.com/news/2011-09-06/zoellick-says-world-in-dangerous-period-as-europe-turmoil-adds-to-risks.html
[2] Journal of International Affairs, 1967, No4, Vol.43
[3] Danilo Mercurio and Vladimir Spokoiny , Statistical inference for time-inhomogeneous volatility models. Ann. Statist. Volume 32, Number 2, 2004
]]> Wed, 07 Sep 2011 16:13:00 <![CDATA[Systemic risk index reaches unprecedented levels]]> http://www.raisepartner.com/rep-edito/ido-73/systemic_risk_index_reaches_unprecedented_levels.html
Concerns on the sensitivity of financial markets

 &ldquo;We are moving into a dangerous period,&rdquo; president of the World Bank Robert Zoellick said in an interview with Bloomberg Television in Singapore today. &ldquo;While the U.S. is likely to avoid a return to recession, escaping with slow growth, the euro zone is facing a particularly sensitive time.&rdquo; (source: Bloomberg [1])

Do quantitative indicators confirm the worries formulated these past months?


The cross-sector correlation level as a relevant systemic risk indicator

The ability of market actors to analyze the real economic dynamics of listed companies plays a crucial role in the stability of financial markets. Industrial sectors do not all have the same fundamental characteristics such as market size and dynamics or supply/demand balance; hence the dynamics of the industrial sector indices usually exhibit some level of independence in normal market conditions.

When the systemic risk is high, the behavior of market actors tends to be driven by a few causal factors (among which liquidity) and all sectors become highly correlated.


Systemic risk higher than in 2008

The current level of cross-sector correlations suggests that the systemic risk is already higher than it was late 2008. The RP Quant Systemic Risk Index,  an aggregated indicator of correlations across the Dow Jones industrial sectors, reached an unprecedented high end of August (220 vs. 210 in 2008):



The value of the index recently jumped from 100 to more than 200 because most cross-sector correlations exceeded 90% these past weeks!

The evolution of the RP Quant Systemic Index since 2007 suggests that financial markets conditions have never returned to normal since the 2008 crisis: the index remains larger than 100 during the whole period. The emergency liquidity injections allowed to limit the damages but do not provide a sustainable solution to the financial market situation.

The implied volatility index (VIX), which provides a measure of instantaneous risk aversion, has not reached its 2008 level yet. But in the current context, the extreme sensitivity of the financial markets could lead the index to similar levels if no sustainable agreement is found between European leaders.

These quantitative observations confirm the concerns brought up by many actors, and underline the necessity to make a concrete step towards what Lord Gladwyn called &ldquo;the necessity for European political integration&rdquo; in [2].


The model behind the RP Quant Systemic Risk Index

The RP Quant Systemic Risk Index is a daily aggregated indicator of correlations across the 10 Dow Jones industrial sectors: Basic Materials, Consumer Goods, Consumer Services, Finances, Health Care, Industries, Oil & Gas, Technology, Telecommunications, Utilities.

The index is defined as follows:



where the dynamics of the cross-sector correlations &rho;_ij (t) is captured via a proprietary risk model based on adaptive estimation techniques in the lines of Spokoiny and Mercurio [3].

 Read the french version


References

[1] http://www.bloomberg.com/news/2011-09-06/zoellick-says-world-in-dangerous-period-as-europe-turmoil-adds-to-risks.html
[2] Journal of International Affairs, 1967, No4, Vol.43
[3] Danilo Mercurio and Vladimir Spokoiny , Statistical inference for time-inhomogeneous volatility models. Ann. Statist. Volume 32, Number 2, 2004]]> Tue, 06 Sep 2011 16:36:00 <![CDATA[Monetary politics, inflation and unemployment: the Taylor rule]]> http://www.raisepartner.com/rep-edito/ido-72/monetary_politics_inflation_and_unemployment_the_taylor_rule.html
John B. Taylor [1] suggests the following modelization of the key rate in his book &ldquo;Macroeconomic Policy in a Word Economy: from econometric design to practical operation&rdquo; [2]. A simple version of the Taylor rule defines the target rate as a function of the inflation rate and the unemployment gap:

Target rate = 1% + 1.5*Inflation - 1*Unemployment gap

where the unemployment gap is the difference between the current unemployment rate and the NAIRU (see glossary).

The objective of theTaylor rule is twofold:
- Follow the rise in inflation to keep it under control
- Promote investment and growth when the unemployment rate deviates from its natural rate

To analyze recent ECB and US interest rate movements, Fernanda Nechio [3]applies the Taylor rule described above to the euro area and to the Federal reserve, and compares the recommended target rate with the actual policy rate:




Since the 2008 crisis, the unemployment gap in the US rised to such a level that the target rate implied by the Taylor rule was negative (as illustrated in the bottom figure)! The conventional monetary policy became ineffective, which is why the FED set the rate to its lowest level (0.25%) and used a less conventional tool to stimulate the national economy: Quantitative Easing [4].

In Europe, the difficulty lies in the definition of a common monetary policy for countries experiencing very different macroeconomic conditions (measured by the unemployment gap, inflation and GDP in the chart below).




There is still a long way to go for European countries to continue their cultural and political integration effort in order to homogenize and strengthen the economic euro zone.



[1] John Taylor is a Professor of Economics at Stanford University, a member of the Hoover Institution, and the former Under Secretary of the Treasury for International Affairs under Bush's administration.

[2] 1993 - New York: W. W. Norton Company

[3] Source: Fernanda Nechio, "Monetary Policy: When One Size Does Not Fit All", FRBSF Economic Letter, June 13, 2011. http://www.frbsf.org/publications/economics/letter/2011/el2011-18.pdf

[4] Quantitative easing (QE) is an unconventional monetary policy tool used by some central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank implements quantitative easing by purchasing financial assets from banks and other private sector businesses with new money that it creates electronically.
]]> Tue, 05 Jul 2011 16:56:00 <![CDATA[Are billions of liquidity driving equity markets away from the real economy again?]]> http://www.raisepartner.com/rep-edito/ido-71/are_billions_of_liquidity_driving_equity_markets_away_from_the_real_economy_again_.html
Meanwhile, US investors poured $1.4 billion into US domestic stocks funds, according to the Investment Company Institute. That was the fourth straight week of net inflows for U.S. equity funds and a big reversal from 2010, when investors yanked an average of $7.3 billion out of U.S. stock funds each month.
Last week U.S. mutual fund investors added a net $2.54 billion to equity funds the majority of which went into US domestic-focused funds (source: Thomson Reuters' Lipper service).

Inflation expectations and aggregate demand
By increasing liquidity Ben Bernanke has probably managed so far to increase expectations for higher inflation and hence for aggregate demand: if buyers expect higher prices in the future, then they increase their demand for goods and services in the present.
The rise of inflation expectations in 2010 was a strong explanatory factor for equity market returns until September 2010 but how long can it work?



















A proxy of break even inflation can be obtained by buying inflation protected bonds ETFs such as iShares Barclays TIPS Bond Fund (ETF) (AMEX:TIP) and selling iShares Lehman 7-10 Yr Treas. Bond (ETF) (NYSE:IEF) to obtain what we call below a Break Even Inflation (BEI) trade.


Equity returns and breakeven inflation trades correlation
How the equity market is responding to positive inflation expectations?



















Correlation (calculated using PRISM SaaS platform) between S&P 500 proxy (SPY ETF) and the Break Even Inflation (BEI) factor went up to 65% end of August 2010. Since then the equity index has grown at a rate of 46% annual return (23% in six months) losing clearly its anchor to the BEI factor: the correlation has been divided by three in a few months. Furthermore the Sharpe ratio of the SPY return over the last 6 months is above 4; which is clearly not sustainable. ]]> Mon, 14 Feb 2011 10:20:00 <![CDATA[Geopolitics & Risk Management : Egypt]]> http://www.raisepartner.com/rep-edito/ido-70/geopolitics_risk_management_egypt.html Bloomberg (January 28th, 2011)  : "Stocks worldwide plunged the most since November, crude oil posted the biggest jump since 2009 and the dollar rose versus the euro after protesters posed the biggest challenge to Egyptian President Hosni Mubarak's 30-year rule. Egypt's dollar bonds sank, pushing yields to a record."

We could add that a risk aversion index such as VIX surged from 16.15 to 20.04 (+24,09%) that day.

No long comments are needed to understand that there exist strong causal relations between geopolitical factors and financial markets. It is not clear yet how to quantify these dependencies. In any case it starts with trying to establish a factual description of the local complexity.

Egypt's army has clearly considered the example of Tunisia's army that has gained a great popularity by refusing to shoot on demonstrators. Egypt's army wants to strengthen its political weight it has been holding since 1952 when monarchy was abolished.]]> Fri, 04 Feb 2011 09:43:00 <![CDATA[Searching for the right substitute to GDP]]> http://www.raisepartner.com/rep-edito/ido-69/searching_for_the_right_substitute_to_gdp.html
In economics, growth is usually referring to GDP growth. GDP is &ldquo;The sum of the final uses of goods and services (all uses except intermediate consumption) measured in purchasers' prices, less the value of imports of goods and services&rdquo; ( OECD Glossary). Does it mean that sustainable growth of goods and services produced leads to sustainability? Is a balanced GDP growth a good guarantee for a balanced growth between developed and emerging countries?

One week before Pittsburgh summit, a commission of specialists chaired by economists Joseph Stiglitz, Amartya Sen and Jean-Paul Fitoussi delivered a report on economic indicators and social progress ordered by French government. They pointed out the discrepancies of GDP as the unique measure of wealth and development. In an interview to a French newspaper, Stiglitz even urged the political leaders to end the &ldquo;GDP fetishism&rdquo;.

While GDP fetishism relates to the extensive use of the measurement rather than the measurement itself, the report points out also many of its flaws : unpaid work like raising children are not included in the calculations, while traffic jam, by increasing fuel consumption, and forest fire, with rebuilding costs, are. Qualitative improvements of the environment, or external benefits, of activities like national parks enhancement are totally dismissed. The biodiversity preservation, the part in water filtering process and the energy boost of a get-away in nature are among them. On the other side, the negative impacts, or external cost, of the wood industry for example can be underestimated.

The panel made some concrete suggestions, such as using NDP* rather than GDP or even household consumption rather than national consumption to reduce the gap between economic indicators and the household's perception of reality. They also put forward the idea of considering social benefits provided by some countries: health care, education, sports facilities, cultural facilities, affordable housing. Therefore the income are more comparable : the adjusted disposable household Income including housework and leisure was 87 in France compared to 100 in the U.S. in 2005, while the unadjusted disposable income not including housework and leisure was only 66 to 100 for the same year. Likewise, the repartition of household income is more representative than the mean of household income.
Providing these recommendations are followed, it will have a great impact and not only on GDP measurement and the way national economies are competing one to another. It will change the way the market is moving on news. GDP is everywhere in portfolio theory : it is a major factor in asset's valuation models (along with CPI, P/E ratio, etc...) (GDP Growth as Risk Factor in Equity Returns), it is used to gain a perspective on a firm's performance under different economic conditions, it explains the demand for each country's money, hence the exchange rates and it allows to select the best investment opportunities between several countries.

With sustainability, economic and social well-being weighting more in the models, countries and companies with awareness on those issues may gain a competitive advantage on the others. Actually, they already have one : Interface, Inc. (NASDAQ: IFSIA) claims to be « the world's largest manufacturer of modular carpet&rdquo; and to have &ldquo;long term commitment to sustainability&rdquo;. From 1995 to 2007 the company saved $372 millions with its environmental-impact reduction action (Sustainability in action).

Rather than a posteriori assessing the positive financial consequences for the economy of such initiatives, shouldn't we consider a systematic quantitative monitoring of sustainability, individual well-being and social welfare so that the market take them into consideration as key factors in assets valuation and explanatory factors for price movements ?

* Net domestic product (NDP) is obtained by deducting the consumption of fixed capital from gross domestic product. Contrary to GDP, it accounts for the fact that while goods are being produced, some resources are used.]]> Fri, 04 Dec 2009 10:24:00 <![CDATA[Towards new stress-test practices in the HF industry]]> http://www.raisepartner.com/rep-edito/ido-68/towards_new_stress_test_practices_in_the_hf_industry.html
Clearly, most existing stress tests failed to identify potential problems during the financial crisis. For instance, the stress tests defined by the Fed are based on "what-if" macro scenarios (GDP, unemployment and house prices) and might fail to predict the impact of risk factors that are specific to an institution or a portfolio.
&ldquo;Reverse stress testing&rdquo; (see [2]) overcomes some of the limits of traditional stress tests and can be used as a complement. These reverse stress tests follow a &ldquo;bottom-um&rdquo; approach (as opposed to the &ldquo;top-down&rdquo; traditional stress tests based on macro scenarios) as they try to determine what specific factors could impact a given portfolio. But it might come short when brutal market changes occur.

In any stress-test approach, one of the underlying challenges is to develop a risk model which is:
- dynamic enough to detect new risk factors as they arise,
- reliable enough not to misinterpret local market noise as a real turmoil.

A good risk model should help define the worst case scenario by identifying the factors to which a specific portfolio is most sensitive. But many Hedge Fund managers have been using models that failed to take into consideration certain risk factors, simply because they had never been seen as risks before, and were not considered as such in their &ldquo;what-if&rdquo; scenarios.


RaisePartner provides risk models that combine unique key properties for the design of tailored stress-tests:
- Specificity is obtained by using a &ldquo;full-rank&rdquo; approach when building the risk model. Indeed, standard factorial approaches are broadly used to explain the &ldquo;ex-post&rdquo; decomposition of the risk but they might fail to detect the rise of new risk factors in an &ldquo;ex-ante&rdquo; risk model.
- Reactivity is achieved by using short estimation windows for the estimation of volatilities and correlations. For instance, a change of sign for a cross-sector correlation can be detected much sooner.
- Reliability is ensured by a patented risk filtering method that distinguishes noise from real market information.


Another key ingredient when defining stress-tests is high performance computing: obtaining the stress-test results in real-time on large universes with a low CPU-cost is crucial for a concrete use of these results. When computing stress-tests at the global firm level, several sectors have to be aggregated, leading to very large universes.

With appropriate risk models and high-performance computing approaches (code tuning), RaisePartner provides unique functionalities for relevant and efficient stress-test computations.]]> Thu, 13 Aug 2009 16:41:00 <![CDATA[Back to basis series (2) - Keynes liquidity dilemma]]> http://www.raisepartner.com/rep-edito/ido-67/back_to_basis_series_2_keynes_liquidity_dilemma.html Financial markets play a key role to provide investors with liquidity and hence enable them to move capital from low-productive savings to highly-productive investments: schooling, training, research, innovation.

On the contrary, capital immobilization is a strong obstacle for investing in the real economy. Indeed nobody is willing to own a piece of a machine producing solar photovoltaic modules since it might not be easy to cash out part of this investment when needed. It is much easier to own a few shares of a listed company such as Applied Materials Inc (NASDAQ:AMAT) to contribute to green investments while being able to get back your money at any time provided that you accept an exposure to market risk and specific risks related to the company.

Hence liquidity is useful.

Yet it is somehow at this very precise point that liquidity becomes dangerous since it is a first transgression of reality: on one hand the real asset remains highly illiquid, and on the other hand, a liquid piece of paper is owned and traded in a financial world that can become a virtual world disconnected from the real world.

This is Keynes famous "Liquidity dilemma": liquidity is needed but too much liquidity can be a source of strong instabilities and destroy value because of its distance to reality and also because it enables contagion of fear from one asset class to another.

Hence liquidity must be monitored; rules and legal barriers must be reinforced to prevent contagions. The second Glass-Steagall Act, passed on 16 June 1933, and officially named the Banking Act of 1933 is a famous example of such anti-contagion rules.

In the nineteenth and early twentieth centuries, bankers and brokers were sometimes indistinguishable. Then, in the Great Depression after 1929, Congress examined the mixing of the &ldquo;commercial&rdquo; and &ldquo;investment&rdquo; banking industries that occurred in the 1920s. Hearings revealed conflicts of interest and fraud in some banking institutions' securities activities. A formidable barrier to the mixing of these activities was then set up by the Glass Steagall Act.]]> Thu, 16 Jul 2009 11:09:00 <![CDATA[Back to basis series (1) - Regulation and market efficiency]]> http://www.raisepartner.com/rep-edito/ido-65/back_to_basis_series_1_regulation_and_market_efficiency.html
"Financial markets must be regulated!"; behind this current unanimity and dominant thought, can't we recognize the troubling signature of "The Market" itself? Isn't it another expression of its powerful strength to make opinions converge as well as to erase discordant or more complex statements?

As John Maynard Keynes used to say : "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally". A majority of market actors wanted to access the high-with-apparent-low-risk subprimes returns. When everything goes wrong the same majority is calling for more regulation.

Regulation or deregulation: what does it mean?

It is not true that "deregulation" means "absence of rules". Indeed from the very beginning of modern stock exchanges in Amsterdam and London in the XVIIth century [1], precise rules and conventions have been organizing exchanges between market actors. Since then and in particular with the marginal revolution of the 1870's, with Carl Menger in Austria, William Stanley Jevons in England, and Leon Walras in Switzerland , these rules have even been highly systematized and even mathematized.

Rules of deregulation have been organized by the "neoclassical finance" to try to reach some specific market conditions, such as pure competition and create an environment where an important assumption, called more recently by Professor Eugene Fama at the University of Chicago Booth School of Business, the Efficient Market Hypothesis (EMH) holds. This assumption is the starting point of very strong and consistent political, economical and intellectual statements. Any contradiction or proposal of improvement of the "deregulated" point of view must take into account this complexity.

For example, in this consistent theoretical framework, not only "speculation" (which is not always easy to define) is not "bad" but it plays a positive role: it enables the conversion of information into prices.

[1] Walker, Gordon,Securities Regulation, Efficient Markets and Behavioural Finance:Reclaiming the Legal Genealogy. Hong Kong Law Journal, Vol. 36, No. 3, 2006; Latrobe Law School Legal Studies Research Paper Series No. 2008-03. Available at SSRN: http://ssrn.com/abstract=1099512
]]> Sun, 10 May 2009 11:36:00 <![CDATA[No Obama contagion on the markets]]> http://www.raisepartner.com/rep-edito/ido-66/no_obama_contagion_on_the_markets.html As president Barack Obama took oath of office, the enthusiasm of the vast crowd attending Obama's inaugural address did not reach Wall street: the inauguration coincided with more bad news from Wall Street, with the Dow Jones industrial average down more than 300 points on indications of further trouble for banks.
The « Obama effect » was swept away by the fall of finance and technology sectors, such as the British bank RBS that lost 70% of its value on Monday 19th.

Investors remain worried of the major crisis Obama is inheriting. The VIX index, which gauges stock market volatility, is another sign of investors' edginess: by jumping to 57, it reaches the highest point since last November. This one-day 22.9% rise is the highest daily progression since last October 22nd.]]> Wed, 21 Jan 2009 11:39:00 <![CDATA[Madoff ]]> http://www.raisepartner.com/rep-edito/ido-64/madoff.html In many ways Madoff's scheme &ldquo;out-Ponzied" Charles Ponzi*. Madoff has been operating his scheme for 20 years, whereas Ponzi lasted eight months only. Madoff lost more than $50 billion, while Ponzi collected $15 million.
Unlike Ponzi, who promised investors 40 percent returns in less than six months, Madoff promised and "delivered" (at least for a while) returns around 10 percent per year. Madoff sold not high returns but consistent returns through bullish or bearish markets.

In Madoff's case, the game might still be going on if hedge funds were not imploding. Many hedge fund-of-fund managers were Madoff's clients. As withdrawals accelerated throughout the industry, Madoff was caught in the tide.

Instead of hard facts and transparency, the fraud relied on word-of-mouth testimonials to attract new clients. Money was given directly to Madoff without safeguards. Madoff's metronomic returns -- never losing money no matter what -- were simply too good to be true. What is striking is not so much the level of returns...but the ability to provide such returns with so little volatility. Indeed, such a risk-free investment would be on the top-left corner of the risk/return chart, with abnormally large Sharpe ratios compared to the Funds industry.

* A Ponzi scheme, named after Charles Ponzi, is a fraudulent investment operation that pays returns to investors out of the money paid by subsequent investors rather than from profit. The Ponzi scheme usually offers abnormally high short-term returns in order to entice new investors. The perpetuation of the high returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors in order to keep the scheme going.
]]> Mon, 15 Dec 2008 11:31:00 <![CDATA[Skewness, hope and bubbles]]> http://www.raisepartner.com/rep-edito/ido-63/skewness_hope_and_bubbles.html As economists Joseph Golec and Maurry Tamarkin have shown*, studies of horse race betting have empirically established a long shot anomaly. That is, low-probability / high-variance bets (long shots) provide low mean returns and high-probability, while low variance bets provide relatively high mean returns. Because bettors willingly accept low-return / high-variance bets, researchers conclude that bettors are risk lovers.

In their study, Golec and Tamarkin show that the data are at least as consistent with risk aversion as they are with risk loving when one explicitly considers the skewness of bet returns. Because the variance and skewness of bet returns are highly correlated, bettors may appear to prefer variance when it is skewness that they crave for.

For the same reason some investors may be easily over-attracted by new financial products (CDOs, commodities) or new industrial sectors, such as the Dot-Com sector between 1995 and 2001. This new investment support may have no track record, even negative expected return but they carry hope for change and hence a positive skewness!

To answer the difficult question "what will be the next financial bubble?&rdquo;, one might ask first where investors hope seem to focus today ? Renewable energy?

* Joseph Golec & Maurry Tamarkin, 1998. "Bettors Love Skewness, Not Risk, at the Horse Track," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 205-225, February.]]> Thu, 20 Nov 2008 18:01:00 <![CDATA[100 seconds to convince at the GAIM conference]]> http://www.raisepartner.com/rep-edito/ido-62/100_seconds_to_convince_at_the_gaim_conference.html We got the chance to present our RP Quant Global Macro strategy at the latest GAIM conference in Geneva, November 12th. This Quickfire showcase consisted in a 100-second talk to explain how our investment strategy differs from others, without using any charts or figures. The strategy was then graded by a jury.

Our CEO François Oustry captivated the audience and got a 10/10 on the strategy (see transcript of the speech below).


&ldquo;I am going to talk about transparency, risk and quant approaches.

Is Quant always relevant?

Of course not - here is what we believe in:

We believe that mathematics are a powerful language that should be used to leverage the intuition of the investment manager and broaden his or her vision.

Take correlation for example: there is no such thing as THE correlation. There are many ways to compute it depending on what you want to do with it - and this very important choice must not be left to a quant black box. We believe that investment managers deserve full disclosure of these choices.


Why are we different?

We use unique reactive risk models and robust dynamic allocation schemes coming from robust control.

Our investment strategy is a Quant Global Macro invested via very liquid instruments such as Equity, Bonds, FX, Commodities ETFs, geographically and sectorially diversified.

Last but not least we enable you via our Web platform PRISM not only to monitor the risk of the strategy but also to replicate the whole investment process.&rdquo;]]> Thu, 13 Nov 2008 17:01:00 <![CDATA[VIX hits an all-time high in October 08]]> http://www.raisepartner.com/rep-edito/ido-61/vix_hits_an_all_time_high_in_october_08.html The CBOE volatility index (VIX) is the most widespread benchmark for stock market volatility. This &ldquo;investor fear gauge&rdquo;, quoted in percentage, gives a reliable snapshot of the expected near-term stock volatility based on the S&P500 option prices.

Since its creation in 1993, this index has been used as a trustful barometer of the investor's anticipations and anxiety. Looking back at its historical quotations since 1996, we can see how the VIX reached new historic levels when vaulting to an unprecedented 81.17 in October (+400% in two months).




This shows how the current crisis is nothing like what financial markets have experienced over the past ten years: for comparison purposes, the aftermath of the 9/11 crisis drove the VIX close to 45...]]> Sun, 02 Nov 2008 17:24:00 <![CDATA[Combining reactivity and robustness]]> http://www.raisepartner.com/rep-edito/ido-58/combining_reactivity_and_robustness.html After reaching unprecedented levels, the oil price has been severely dropping since last July. The oil barrel lost about 40% of its value in less than 3 months.

To what extend can quantitative models help to detect such drastic changes on the markets? Are there signals, information on the market that can be used to design reactive investment strategies?

The RP Quant Global Macro Index is an example of how well-tuned quantitative models can help build reactive and robust* strategies.

The chart hereafter shows how the oil position on the RP Quant Global Macro Index started decreasing one month before the oil barrel began to drop.


Oil performance (orange) vs. oil weight (green) in the RP Quant GM Index


How come? Why did the quantitative model choose to withdraw from its oil position whereas it was on a positive trend at that time?

First, this example shows that momentum performance signals can be efficient. The RP Quant Global Macro Index is based on a short-term trend-following performance model, and this has been paying off for the first semester 2008: the oil position was reinforced to benefit from its bullish performances.

BUT a trend-following performance model can be very dangerous when it is not associated with a reactive risk model that forces you to go out of the trend soon enough when market conditions are deteriorating.

This reactivity (which should not be confused with market anticipation) is due to the dynamic risk model on which the strategy is based on. Indeed, by associating short estimation windows and market noise filtering approaches, the RP Quant Global Macro strategy is able to detect soon enough changes in the dynamics of the volatilities and correlations.

As an example, we can see in the chart below that the weight decrease in the oil position coincides with a sudden 5% rise in the oil volatility. As a consequence, the oil Sharpe ratio became not so interesting even if the trend was still positive. It is this ability to detect short-term changes in the dynamics of the risk measures that allowed the RP Quant Global Macro Index to safely cut back on the oil position soon enough.



Oil volatility(yellow) vs. oil weight (green) in the RP Quant GM Index

*Robustness is to be taken in the sense of the Robust Control Theory.
]]> Mon, 27 Oct 2008 16:17:00 <![CDATA[RaisePartner sponsor of GAIM Geneva]]> http://www.raisepartner.com/rep-edito/ido-59/raisepartner_sponsor_of_gaim_geneva.html RaisePartner is sponsoring the next Fund of Funds GAIM event taking place November 11th, 12th and 13th in Geneva. This conference will deal with the challenges and opportunities in a changing investment and economic environment.

Come and meet us at our exhibition stand!]]> Thu, 23 Oct 2008 16:46:00 <![CDATA[RaisePartner in Australia]]> http://www.raisepartner.com/rep-edito/ido-60/raisepartner_in_australia.html RaisePartner participated to the last Q group colloquium that was held in Sydney on October 16th.

Among the many Quant topics that have been discussed, Véronique Piolle and François Oustry presented a Global Macro investment strategy with positive asymmetry preferences.]]> Mon, 20 Oct 2008 11:47:00 <![CDATA[Triple-witch day: a not-so-freaky day after all?]]> http://www.raisepartner.com/rep-edito/ido-57/triple_witch_day_a_not_so_freaky_day_after_all_.html triple witching day took place on Friday June 20th, as the contracts for stock index futures, stock index options and stock options all expired on the same day. Triple witching days (also known as &ldquo;freaky Fridays&rdquo;) happen four times a year on the third Friday of March, June, September and December. This coincident expiration of quarterly options and futures increase the volatility of the market, as traders quickly offset their orders before the market closes.

This phenomenon used to be a big deal back in the 80's (before the 1987 crash): at the time, it was the source of arbitrages which impacted the market volatility a few days before and after the triple expiration day. But the triple witching day isn't what it used to be, due to the markets mutations since the 80's.

One of the biggest changes since then is that the equity options (stock options) list on cycles other than the March-June-September-December quarterly cycle, which lowered the impact of the stock options expirations.

Also, all three instruments used to expire at the same time which created a lot of incentive to hold on to the positions until the very last minute. Today, the stock index futures and the options on those futures and stock options all have slightly different expirations starting from the close on Thursday to the close on Friday. These few hours of mismatch between the expirations make it impossible to engage in massive arbitrage which would require precise timing in execution. As a result, financial actors begin to offset the positions a few days before the actual expiration. And this too spreads the impact over a longer period and therefore reduces the impact on the market volatility.]]> Thu, 26 Jun 2008 19:05:00 <![CDATA[Reading and using the VIX]]> http://www.raisepartner.com/rep-edito/ido-56/reading_and_using_the_vix.html On June 6th , the VIX experienced a major 5 points rise (jumping from 18.6 to 23.5) due to the US unemployment report, the falling dollar and the skyrocketing oil barrel price. The Quant Market Watch column seizes this opportunity to insist on the role and the limits of this « investor fear gauge » and see how it can be used by investment managers to improve their risk modeling approach.

The VIX (the CBOE Volatility Index) is the most widespread benchmark for stock market volatility. This &ldquo;fear index&rdquo;, quoted as a percentage, gives a reliable snapshot of the expected near-term stock volatility based on the S&P500 option prices.

The VIX proved to be a consistent and useful flag in the past crisis: each time the VIX rose brutally, it corresponded to a significant regime change in the stock market conditions (see charts below as an example).



Investors have been using the VIX for a while to get the real-time market temperature: but how can investors use this instantaneous market information in a more systematic way to better apprehend their risk?

Why use the VIX?
Historic-based risk models, as advanced as they might be, are not able to detect short-term regime changes on the financial markets. Indeed, time-series have a smoothing effects on recent perturbations, which could lead to a dangerous under-estimation of the risk taken.

Limits of the VIX
So why use historical data in the quantitative risk modeling approach? Historical information remains fundamental for a fine risk modeling and a dynamic estimation of the interdependences. Using the sole Volatility Index as an input for the risk estimation might give too much importance to localized picks of volatility, hence ignore the global trend.

How to use the VIX
Finding the right trade-off between instantaneous and historical information is the key: as simple as it may sound, this mixed approach requires adaptative modeling tools to be able to aggregate the information in a consistent yet systematic way.

How about other asset classes?
Stock volatility indices are available for a wide range of geographical zones and different time-horizons, inspired by the CBOE VIX methodology. But there is still no widespread benchmark to measure the short-term volatility for asset classes such as the commodities, foreign exchange,... Still, there exist some modeling approaches to rebuild such indices &ldquo;in-house&rdquo;.]]> Fri, 13 Jun 2008 16:42:00 <![CDATA[CPI: an optical illusion?]]> http://www.raisepartner.com/rep-edito/ido-55/cpi_an_optical_illusion_.html Since the publication of the lower than expected American CPI (Consumer Price Index), the dollar has been entering a new bearish cycle. But this could be seen as an impulsive reaction of the market: indeed, a refined analysis of the inflation dynamics shows that inflation is greatly accelerating. The CPI that was published last week is estimated based on an aggregation of recent and older data, going back to spring 07, before the rise in commodity prices. As a consequence, it does not capture the real short term inflation dynamics. Over the past 3 months, the CPI gained 1.2%, which corresponds to a 4.8% annual rate!

Last Tuesday, the Fed reasserted that it would actively work on the liquidity issues through the mechanisms introduced during the crisis:
- Creation of the Primary Dealer Credit Facility
- Reduction of the spread between the primary market and the Fed rate
- Extension of the short-term loans to 90 days
- Creation of the Term Auction Facility

The success of these mechanisms allows the Fed to dissociate the liquidity issues and the adjustment of the Fed rate, so that the latter can finally get back to its initial role as an inflation control variable. Ben Barnanke held a firm position last Tuesday at the Atlanta Conference: in the current liquidity conditions, the Fed will not hesitate to increase its rate as soon as the American economy shows the first signs of rebound.]]> Mon, 19 May 2008 19:55:00 <![CDATA[One emergency after the other]]> http://www.raisepartner.com/rep-edito/ido-54/one_emergency_after_the_other.html The Fed is expected to lower its rate one last time this week before announcing the end of the rate cut cycle started last September.

Its president Ben Bernanke is dealing with one emergency after the other: the main objective since August has been to deal with the subprime crisis and the risk of collapse of the American financial system. By lowering the interest rates from 5.25% to 2.25% over the past 7 months and by bringing its support to the American banks, the Fed tried to put an end to the financial crisis. Bad news will keep on making the headlines for the next few months, but they should not take the markets out of guards anymore.

President Ben Bernanke is now about to focus on a new emergency: the American inflation amplified by a weak dollar. The first goal of the rate cut was to give some breathing space to the banks, but it has also impacted the US currency. Indeed, as the dollar investments were lesser and lesser attractive, investors sold their dollars to buy more remunerative currencies, especially Euros.
While the Fed was busy trying to put out the subprime crisis fire, the dollar kept weakening against the main foreign currencies, making life more expensive everyday for the American household: as the oil and food prices keep rising in Euros, it is even worse in their weakening domestic currency!

To control this inflationary cycle, the Fed might signify the market that the cut rates will soon be over. Furthermore, if the dollar - the reference currency for the oil trades - were to gain strength, the petroleum exporting countries would be able to settle their earnings without counting on the raising barrel price.]]> Tue, 29 Apr 2008 11:08:00 <![CDATA[Capital inflow towards emerging countries]]> http://www.raisepartner.com/rep-edito/ido-53/capital_inflow_towards_emerging_countries.html
According to the &ldquo;law of diminishing returns&rdquo;, capital should have flown faster towards the emerging countries.

For a long time the classic economic theory relied on the sacrosanct "law of diminishing returns". This law lies on an intuitive idea: the bigger the money invested in an economy (be it a country or a company), the more friction there are and the more the injected fuel is burnt. The upstream production means get congested while the downstream distribution channels get saturated. The losses implied by these frictions lead to a decrease in the productivity: the USD million invested in a friction-free economy produces much more than the USD million invested in a mature hence more saturated economy.
In 1990, the 1995 Nobel Prize winner Robert Lucas wrote an article untitled &ldquo;Why Doesn't Capital Flow from Rich to Poor Countries?&rdquo;. In this article, Robert Lucas explained that the classic economic models forecasted a return on capital much larger in the emerging countries than in the occident. In India for instance, the theoretical rate of return on capital was expected to be 58 times larger than in the US!
Obviously, if such a gap had been verified, massive capitals move from the rich (saturated) countries towards the emerging (expending) ones would have taken place during the 20th century. But this was clearly not the case: why?

The main capital attraction factor is the accumulation of know-how and learning-by-doing, an intangible asset of the worldwide economy.
There are many political and geopolitical reasons but these factors are not sufficient to explain the gap between the theoretical and real figures. As explained by Robert Lucas, the economists introduced a new key factor to explain the capitals moves: the factor of know-how accumulation. This know-how includes knowledge, technology, innovation and process leading to the production of goods or services. Taking this factor into account allows to overrides the gap with theoretical rates of returns.

Investing in education is the key to a lasting growth

Over the past 15 to 10 years, India, Asia and the Gulf countries have been massively investing in the accumulation of know-how and learning-by-doing within their borders but also in other emerging countries, in particular in the MENA zone (Middle-East North Africa). The growing financial stocks and their mobilization into intangible assets could provide these countries with return on capital (adjusted according to the country-specific risk) larger than those of the mature countries.
By launching ambitious education, research and learning programs, by stimulating its demographics by collaborating with the Southern countries, Europe may stay in the race and call a halt to the economy slowdown.

[1] Lucas, R (1990), « Why doesn't capital flow from rich countries to poor countries? », American Economic Review, Vol. 80, No. 2 (May), pages 92-96.
]]> Mon, 21 Apr 2008 10:20:00 <![CDATA[A world economy caught between fire and ice]]> http://www.raisepartner.com/rep-edito/ido-52/a_world_economy_caught_between_fire_and_ice.html Thursday April 10th, the day before the G7 summit, the International Monetary Fund director Dominique Strauss-Kahn called for strong vigilance, referring to the growing signs of inflation in a worldwide low-growth economical context. Caught between &ldquo;fire and ice&rdquo;, the governments do not have much breathing space left.

DSK also underlined that the rising food prices would not help the poverty reduction efforts worldwide, and could become a source of tension in Africa and Asia. Providing the poor nations with a financial help will give them some air on a short-term basis, but it will be necessary to overcome the food production limitation for a long-term solution.

According to the IMF, the 2008 American growth should be around 0.5%, which would impact the worldwide economy and the emerging countries as well; Asia could loose up to 1.7 growth points but still keep a 6.2% level. DSK underlined the importance of those countries in the financial and economical worldwide equilibrium, and said that upcoming changes in the IMF organization would lead before the end of the year to increased vote rights for the emerging countries.

This optimism is considered cautiously by the concerned countries. In Argentina, the secretary of Finance Martin Lousteau refered to this IMF reform as a really modest first step towards an increased representativeness of the southern countries.]]> Mon, 14 Apr 2008 10:17:00 <![CDATA[US household confidence at its lowest]]> http://www.raisepartner.com/rep-edito/ido-50/us_household_confidence_at_its_lowest.html The drop in real estate prices and the credit crisis are at the root of the American economy current decline.

The real estate crisis - As opposed to the 1991 and 2001 recessions, the current slowdown of the American economy is not being deliberately provoked by the Fed to hold back the inflation. This time, the starting point of the crisis is exogenous and is not controlled by the Fed: the real estate bubble burst. Real estate prices have dropped 10% since the 2006 peak. Martin Feldstein, president of the National Bureau of Economic Research, expects an additional 10% drop in the upcoming months. Each 10% drop lowers the household consumption of USD 100 Mds through a twofold impact: impoverishment of the consumers and the lack of confidence regarding what the future holds. This consumption decrease directly implies the destruction of hundred of thousands jobs, which impacts the household confidence hence the consumption. It is the starting point of a vicious circle with major economical and political consequences.

The credit crisis - In addition, the financial institutions have lost confidence in their assets' value, hence in their ability to find liquidity on the market. As a consequence, these institutions are more and more reluctant to lending to companies, compelling them to reduce their investments, restraint their ambitions and hire less (or even lay off). Through these companies, the credit crisis also impacts the American household confidence. According to Matin Feldstein, this loss of confidence, if confirmed in the upcoming weeks, may be the sign that the current crisis could last long, like the 18-month 1981 crisis...

Short-term measures to restore hope - The US government will have a hard time straightening out the confidence of American household, and will first focus on restoring the confidence of investors and entrepreneurs in the financial system. This week-end, the US Secretary of the Treasury Henry Paulson called for more regulation and considered creating news supervisory agencies and granting wider investigation and interference power to the Fed. These measures may help the financial markets bounce back at short term, but will not last while the Americans will not have their unwavering confidence back.]]> Mon, 31 Mar 2008 19:12:00 <![CDATA[Towards a coordinated action of the central banks]]> http://www.raisepartner.com/rep-edito/ido-49/towards_a_coordinated_action_of_the_central_banks.html The Fed and the European Central Banks have put up an emergency direct line so as to intensify the transatlantic collaboration and avoid the collapse of the occidental financial system. The Financial Times stated on March 21st that a coordinated action of the central banks for a massive buyback of the subprimes-related financial products was being considered.

The objective of this collaboration would be to put an end to the subprime vicious circle: the banks and investment funds are compelled to sale their subprime-related assets, leading to a massive depreciation of their prices. This depreciation directly impacts the balance of these institutions, making it more difficult for them to access liquidity through interbank loans. As a consequence, credit is becoming more and more expensive and restricted, hence impacting the real economy: as it is more and more difficult for companies and individuals to borrow, consumption and growth are slowing down.This is refered to as the financial accelerator studied by Ben Bernanke when he was a professor at Princeton university. From 2005 to 2007, this accelerator was the fuel of the subprime bubble; it has now turned against this very same system to speed up its fall.

According to the Financial Times, the Bank of England would be willing to ally its forces to the European and American counterparts. The Fed refuted the claim that a coordinated action was taking place, but this is not contradictory with possible individual (or partially coordinated) actions to buy back the subprime-related financial assets. The European Central Bank seems reluctant to this idea: to allow an intervention with such a large scope, the 15 government of the EU would have to come to an agreement.]]> Tue, 25 Mar 2008 15:10:00