Category Archives: speculation

Cash & Carry, #3: the Price of “Peso” Risk

In our previous post in this series, we highlighted a line of research by Burnside et al. that explains the profitability of the carry trade as a “peso” problem. That is, the historical data doesn’t completely reflect all of the bad outcomes that may arise. The as yet unobserved bad outcomes are known as “peso events”. The historical profitability of the carry trade, isn’t the complete story. It’s a biased sample. The few bad outcomes not yet observed resolve the puzzle. Investors are worried about these “peso events” and price the currencies accordingly.

In this post we want to delve a bit more into this issue of how investors may be pricing “peso events.”

There are two different aspects to pricing “peso events.” First, we must assess the probability of an extreme negative event. Second, we must assess the discount we want to apply to that negative event. This second aspect is what we want to focus on.

In finance all dollars are not created equal. Cash received in states when the investor otherwise has plenty cash is not worth as much as cash received in states when the investor otherwise is short cash.

The standard models for pricing risk – such as the CAPM, the Fama-French and the Carhart factor models, among others – are based on what is called a linear stochastic discount factor across all states. They assume a linear relationship between the discount factor and some underlying risk factor. In the CAPM, that would mean a linear relationship between the discount factor and the payoff on the market portfolio. But there isn’t any natural presumption in favor of linearity in the discount factor.

The argument made by Burnside et al. is that the discount factor is not linear. Instead, a very high discount factor is applied to the as yet unobserved “peso events.” And this very high discount factor is essential in making sense of the historic profitability of the carry trade strategy.

In order to make the argument more accessible, we have constructed a simple numerical example:

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Cash & Carry, #2: Pesos and Steamrollers

In a previous post, we reported on the evidence that the carry trade strategy – investing in currencies with high interest rates and borrowing in currencies with low interest rates – earns high returns with low risk. In this post we describe in more detail some of what is known about the risk and return tradeoff on a carry trade investment. Our focus is on the risk and the cost of risk.

The returns to the carry trade, like the returns on a number of other trading strategies, are sometimes characterized by the phrase “They take the stairs up, but the elevator down.” That is, the profits accumulate gradually, but once in a while there arises a very, very large loss. The figure below, taken from a recently published paper by Burnside, Eichenbaum, Kleschelski and Rebelo (here is the free working paper version), shows the distribution of returns to a carry trade strategy between 1987 and 2009. The shaded bars are the observed sample. The black line is a normal distribution with the same mean and standard deviation as the sample.

What you can see in the figure is that the sample has a fatter left tail than the normal distribution, as highlighted by the red circle. Those few bad returns are the events at issue. They are very bad, and although few, they occur much more often than is predicted by the normal distribution. And these few extreme events matter to the total return of the strategy: Harvard’s Jeffrey Frankel noted that “In one week of 1998 (October 4-10), the yen rose 16% against the dollar, thereby suddenly reversing years of profitable carry trade from the low-interest-rate yen into the higher-paying dollar.”[1]

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Cash & Carry, #1: Where to Park?

Holding cash is a key risk management tool, and corporations are holding more cash than ever. Where should the corporate treasury park that cash? In which currency should these balances be held–US dollars, Euros, Yen, Swiss Francs, Australian Dollars or what? The choice of the currency denomination of cash investments is the flip side of the problem of selecting the currency denomination of debt. Modern capital markets confront corporate treasury with a broad array of opportunities for borrowing and investing in various currencies.

Assuming the expected returns in all currencies are fairly priced for risk (i.e., Uncovered Interest Rate Parity holds), the answer will depend on the multinational structure of the company’s business and its exposure to fluctuations in the different currencies. Some companies will be better off stashing cash in dollar denominated securities because they anticipate future net cash outflows denominated in dollars, while others will be better off stashing cash in Euro denominated securities and others in Yen, and so on. Many companies will have an optimal mix of cash stashed in a variety of currencies. We’ll call the company’s optimal mix under the assumption of Uncovered Interest Rate Parity the company’s Benchmark currency portfolio.

Other factors will matter, too, such as international tax rules, concerns about capital controls and so on.

But what about that big assumption we made up front? What if expected returns in all currencies are not fairly priced for risk, so that Uncovered Interest Rate Parity does not hold? What if investments in certain currencies are generating big profits, while investments in other currencies are generating losses?

It is well documented that a speculative portfolio built by purchasing high interest rate currencies and selling low interest rates currencies—the carry trade portfolio—has been very profitable over many years.The figure below, taken from a recently published paper by Burnside, Eichenbaum, Kleschelski and Rebelo (here is the free working paper version), shows the cumulative return to an investment in the carry trade portfolio between 1976 and 2009 as compared against the cumulative return to an investment in US stocks and the return to an investment in US Treasury Bills.

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There are speculators and then there are speculators

There has been renewed discussion and debate again about the impact of speculators in the oil market. Some of it has been occasioned by recent enforcement actions against illegal activity.

  • In May, the US Commodity Futures Trading Commission (CFTC) filed civil charges against Parnon Energy, Arcadia Petroleum and Arcadia Energy SA as well as two individuals for manipulating the price of crude oil in 2008.
  • The US Federal Trade Commission this week confirmed it had opened an investigation examining whether oil companies, refiners or traders had manipulated crude oil prices.
  • The InterContinental Exchange this week fined Goldman Sachs for “disorderly trading” in crude oil futures which distorted prices.

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The cloud in silver pricing

On Thursday, May 5, commodities markets fell sharply. On that day alone, the DJ-UBS index of commodities prices lost 4.7 per cent. The rout is said to have started in the market for silver, but rapidly spread to a wide range of commodities.

Silver is used for commercial purposes. Recently, however, the metal has been trading predominantly as a speculative asset. A lot of people now associate silver with the role traditionally given to gold as a store of value against the erosion of fiat money. As such, the price of silver, instead of reflecting the value of the stream of income derived from the traditional commercial uses, is driven by changing beliefs about grand macroeconomic events. This is how silver has gone up by more than 70 per cent in just three months, between the end of January and April 29.

Silver prices halted their rapid ascent with an abrupt fall of 28 per cent in the first week of May. Fundamentals can hardly explain such a violent reversal. Searching for an answer, many pointed their fingers at the Exchange, which raised margin requirements on futures positions four times for a total increase of 61 per cent since April 25. Three increases happened in just five trading days. The argument goes like this: many investors, surprised by the repeated large margin increases were unable to quickly arrange financing of the margin and were forced to sell their positions, driving the price down. This selloff may have been aggravated as other investors panicked. Some complain that the Exchange was deliberately, and unfairly, trying to push prices down. Others use the occasion to press the political case in favor of more aggressive use of margin requirements as well as position limits to stop speculators from inflating the price in the first place.

The events of the last couple of weeks in the silver market are a useful opportunity to briefly review the role of margin requirements and what is known about their impact on trading and prices. Continue reading

Should corporates manufacture inflation hedges?

Reuters’ Breakingviews has a column suggesting that a number of corporates are issuing floating rate debt in order to service the demand of investors for an inflation hedge. Recent issuers mentioned are Berkshire Hathaway, General Electric and MetLife. The column is entirely conjectural on whether this is the actual motivation of these companies. And the column makes much of a tiny sample  and short window. But…

There is very good evidence that companies are more likely to choose a floating rate issue over fixed when the yield curve is steep as it is today and has been for a while. The recent literature began with a paper by Michael Faulkender (now at UMaryland) in the Journal of Finance. There has been a long stream following that. Faulkender studied issuance by companies in the chemical industry and found:
(i) their exposure to interest rates did not predict their choice of floating vs. fixed interest rate debt — i.e., hedging needs did not drive the choice, and
(ii) the price of interest rate risk did not predict their choice –i.e., they were not selling the highest value security.
Instead, the companies appeared to be choosing floating vs. fixed in order to:
(a) manage earnings, or
(b) ride the yield curve, a familiar and dubious speculative strategy.

The Reuters conjecture that corporates are giving bond investors the inflation hedge they deserve is at odds with Faulkender’s results. It matches explanation (ii) above, which the data did not support. In my mind, Faulkender’s results are very weak on (ii) because it is very hard to measure this sort of thing. So perhaps these issuers are providing the market something it demands. Right now, however, there is little substantive evidence in favor of the Reuters conjecture and good evidence that company financial officers have all the wrong incentives and are insufficiently monitored and disciplined for gambling on interest rates.

It’s Not Enough to Reward Performance

The most recent issue of the Quarterly Journal of Economics has an interesting article by Dean Foster and Peyton Young on the gaming of compensation schemes by portfolio managers. They demonstrate that any compensation scheme based exclusively on performance, without conditioning on any information about the actual underlying investment strategy, can be gamed. It’s not enough to reward performance alone. What’s necessary is transparency in managers’ positions and strategies. Then it’s possible to structure a viable compensation contract.

In an earlier post we emphasized that good governance of risk managers at non-financial companies requires making distinctions between types of strategies. The Foster/Young results, while developed for investment managers, have relevance for corporate risk managers, too. Only by scrutinizing risk managers’ positions and strategies can the company incentivize the right kind of hedging.

Sorting the Hedgers from the Speculators

Financial regulators are often in the position of attempting to proscribe or regulate certain types of trading activities. The Dodd-Frank financial reform legislation prohibits banks from proprietary trading. Futures regulators are often in the position of trying to distinguish hedging from speculating.

The task of sorting the different types of activities can be difficult. Cynics of all stripes exaggerate the impossibility of the task. Some belittle efforts to regulate by claiming that the different types of trading aren’t really different in any essential way, so that all regulations come down to arbitrary and ultimately counterproductive regulations. Others hype the ability of traders to evade any regulation by means of crafty relabeling, so that the regulation ultimately has no effect. These discussions are often poisoned from the start by the partisan nature of any debate about government regulation, so that it is impossible to get into a substantive discussion about real distinctions in different types of trading. But the need to make distinctions isn’t unique to the regulatory sphere. It is a general feature of good governance. Even corporate managers are tasked with defining the types of trading that the company’s own risk managers will be allowed to pursue on behalf of the shareholders.

Francesco Guerrera of the Financial Times called attention to a paper of William Silber’s in which he documents the distinctive footprint of proprietary trading. This is exactly the type of substantive discussion that is needed. Making the distinction is difficult, but that doesn’t make it impossible, and the distinction is critical.

Every non-financial corporation that seeks to hedge risks using derivatives needs to be able to make a similar distinction between hedging and speculation. It will want to prohibit its traders from conducting speculative trades. And all proprietary trading is speculation, so that’s a good place to start. The relevant footprint distinctions are going to be a little different from what Silber highlighted, since he was addressing financial institutions. But the idea will be the same.

Mario Goes to the FX Market

Nintendo’ management has decided to keep in US$ a significant fraction of its revenues from exports. Nintendo has a large $7.4 billion pile of cash held in foreign currencies (70% of Nintendo’s total cash reserves). See this Wall Street Journal article.

With the sharp rise in the Yen since May 2010, after a crisis in the Eurozone erupted, and recently with the FED stimulating the economy with an aggressive monetary policy, Nintendo has accumulated large currency losses, when most of the other large currencies (Euro, Sterling and $) depreciated against the Yen.

Does it matter?

At first, one would say no. These are merely translation losses, and the competitive position of Nintendo (its ability to sell its products) is not affected by accounting losses. Moreover, Nintendo has expenses in foreign currency, so matching its revenues with operating costs in foreign currency makes sense.

This is not entirely correct, however.

Nintendo has over the past years aggressively shorted the yen to invested in other currencies, and taken advantage of higher yields abroad when compared with almost zero interest rates in Japan. This foreign currency strategy goes by the name of carry-trade, and has been massively employed by both Japanese companies and households since the late 1990s. It yielded very large gains until the eruption of the current financial crisis. Since then, investors and companies in Japan have used this strategy on and off depending on market conditions.

The Japanese Yen, like the Swiss Franc, is a currency of refuge to investors when markets get nervous. In recent years, the correlation between different measures of market volatility (for example, the Vix and iTraxx) and the Yen has been pretty high. When investors become more risk averse and fearful they go long the Yen, and when markets calm down and volatility declines, the Yen tends to lose its value. The point is that a lot of companies and individuals use the Yen to express their fears about deteriorating economic and financial conditions. And there’s plenty of that nowadays.

What this means is that, in addition to matching the currency in which its cash is held with the currency of its cash flows, Nintendo’s management has deliberately made a bet on currencies with the shareholders’ money. And recently, the bet has lost money, as in the past it has made money.

This begs the following question: Should Nintendo’s management use shareholders’ money to bet on currencies, or should it let investors decide by themselves on currency betting?

It is obvious that the majority of Japanese shareholders in Nintendo are upset with Nintendo’s currency losses, as they were presumably quite happy when Nintendo was making profits in the past from its portfolio of foreign currencies. But the management should not be surprised with shareholders’ reaction. Shareholders give the management discretion as to how retained earnings are invested, but voice their disapproval when management decisions go wrong. Betting on currencies is no different from any other investment decision. Except for the fact that Nintendo’s management has no business on betting on currencies. It’s hard to make a case that they have particular skills in doing that.

The other part of the problem relates to executive compensation. More precisely, how currency betting is treated in compensating management. Often times, currency losses and gains are not treated symmetrically in managerial compensation. Because of this, the management might be inclined to take currency bets, if it can persuade shareholders that currency gains are the result of its talent, and therefore should be followed by unexpected higher bonuses, while at the same time currency losses are not penalized with lower bonuses. How the compensation is designed creates the incentives to act so as to maximize the chances of getting the targeted compensation. Moreover, executive compensation is not entirely outside of the management’s control, and can be subtly manipulated by managers. In general, managers are smart operators, and are able to focus the attention of shareholders on operating profits when (financial losses such as currency losses) occur, claiming that these are unpredictable, and therefore not their fault. Shifting shareholders’ attention on different results ex-post is a very common managerial tactic.

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