In the recent investor surveys a number of hedge fund strategies stand out as strategies which investors expect will do well going forward and which they intend to increase their exposure to. Among these are distressed credit, global macro and CTAs. Of the three, distressed debt hedge funds had a poor 2008 whereas macro and CTAs did well. The naïve reasons for favoring distressed debt are that the world is in recession, default rates are expected to surge. Quite what condition the companies are in when they do file is another matter. I have no comment about CTA’s.

Investor expectations about macro are interesting. They expect macro to perform well in 2009 and beyond. Given the nature of macro investing, this implies that investors have some sort of macro view, at least loosely. If it is volatility in markets in general, then the probability of loss is enhanced as much as the probability of gain. Manager selection is of course paramount and what allows investors to generate more gains than losses out of volatile markets. Risk management at some level requires the investor or their manager to scale leverage to take into account underlying market volatility in the first place. These are more technical matters.

It seems that there is a tendency for investors to chase returns, to prefer strategies or managers which have been doing well recently. We can critique this approach in general or we can look specifically at the preference for macro in 2009. The clear macro trends that macro managers capitalized upon in 2008 were:

• Short rates would fall, long rates would rise. (Clear)
• Rates would reflect public balance sheets. (could take some time to manifest)
• Exchange rates would reflect risk aversion, thus strong JPY, strong USD. (not so clear)
• Credit spreads would widen precipitously. (Clear)
• Equity markets would fall. (Clear)
• Volatility would rise (Clear)
• Long rates would eventually fall as deflation risk set in. (not so clear)

Whether these were clear before the fact we cannot tell. Maybe macro managers were smart enough maybe they were lucky. We hear about the successful ones. Many of the trades were event driven, signaled by the collapse of one financial institution or the rescue of another or some narrow escape.

In 2009 what are the macro trends that managers could capitalize on?

• Short rates go to zero and stay there. (Clear)
• Long rates fall further. (not so clear)
• Weak USD (not so clear)
• Equities will fall (could take some time to manifest)
• Credit spreads recover (not so clear)
• Volatility will remain high (not so clear)

Where are the catalysts and events? There are the various rescue plans but these are for the moment limited to the housing, banking and asset backed markets in the US. Default rates will most certainly rise. But these are events more traditionally traded by ABS specialists and distressed credit investors. Where are the big macro events? One could argue that all the big macro events are behind us and that the path of the economy now follows the excruciating process of deleveraging, consolidation and repair, and releveraging. If so, where are the easy pickings for macro? Investors are likely exhibiting serially correlated expectations based on the recent performance of the strategy class and will likely end up disappointed.

Macro managers work by forming a view of the macroeconomic conditions that will unfold and then take bets to reflect those views. Whether they be in relative value or directional macro trades, whether they are long and short different parameters of the same market, most macro trades are expressed in the levels. For example, a curve steepener long 2s and short 10s, is betting on the levels of the 2 yr rates and the levels of the 10 year rates. Fewer managers trade the gamma of these markets as part of a macro strategy, an approach that adds a dimension which may be useful in a year when the traditional macro pickings are less obvious.

14 April. Retail sales numbers in the US disappointed. Retail sales less autos shrank 0.9% against a forecast of 0.0% and a prior of +0.7%. Advance retail sales were -1.1% versus a forecast +0.3% and a prior -0.1%.

PPI numbers were also reported. PPI Ex Food and Energy rose 3.8% YOY versus a forecast 4.0%. The PPI Index fell 3.5% YOY against a forecast fall of 2.2%. Monthly numbers were negative.  All in all the numbers were not indicative of inflation and if anything signalled deflation risk.

The reaction of the equity market was an immediate dip. European markets which were up about 1.5% at that point quickly fell to down 1.5%. They have since recovered.

The news is bad. Retail sales numbers missed by a mile. PPI numbers signalled deflation risk. How the markets finally close today will be interesting. If they shrug of the bad news, then sentiment remains buoyant and the rally may extend a bit furter. Otherwise the downdraft is likely to be substantial as we move into 1Q results season and have nothing but bad news to look forward to.

Black Swans?

1. 1. Whatever you do, whatever they do, whoever they are, whoever you are, economic cycles will survive. See my article of 2 April 2008. The path of economic growth and the role of central planners.
   2. People learn from their mistakes. The next mistakes they make will be fiendishly novel and clever.
   3. If it is breakable it will break. It is nearly impossible to say when this will happen. In the meantime, it all looks pretty unbreakable.
   4. Trying to make it unbreakable is like getting people to learn from their mistakes. New ways to break stuff are quickly found.
   5. After it is broken, an arbitrary number of people will tell you they told you so, and for an arbitrary number of reasons. Some of these will actually be people who did tell you so. Of these most of them have been telling you so for the last 12 centuries and so would have almost surely been right eventually. Of those who only recently told you so, before the fact, most of them just got lucky. The others are probably the ones who broke it in the first place.
   6. An arbitrary number of persons will tell you how to make it unbreakable. Some of these will be people who told you so. You can recognize them, they are the loudest.
   7. If after considering their solutions you think some of them sound reasonable, refer to 4 above.
   8. Bad things will happen, they always have and they always will. So will good things. The trick is to avoid letting the bad things completely destroy you. So that you will be around for the good things. And when bad things happen, some of the bad things will happen to you. The only way to avoid all the bad things is to avoid all the good things as well, since we never really know if something is a good thing or a bad thing until it’s too late. If you think that everything that happens is a good thing, the next bad thing that happens will be the last thing that ever happens to you. If you think that everything that happens is a bad thing, the last thing that happened to you will be the last thing that ever happened to you. And that’s no way to live.

In 2008, investors quickly became acquainted with the concept of liquidity, or the lack of it. But what do we mean by liquidity, and how do we price it?

Liquidity premia are already priced in some markets such as the treasury market where the spread between on and off the runs is the implied liquidity premium. But how about markets where you have a single asset and there is no concept of off and on the runs? I would like to look at liquidity from the point of view of option implied volatility in order to understand the relationship between volatility and liquidity in more detail. There are two effects at play which are somewhat inter-related which complicates how we think of the dynamics between volatility and liquidity. I would also like to think of these relationships in a non-mathematical way to avoid the complexities that mathematical rigor would introduce. Let’s just get the picture right before we go further.

Volatility tends to rise in liquidity crises. There are two possibilities here. The first is that volatility increases with decreasing liquidity. The second is that the unobserved continuous time volatility is unchanged but that decreased liquidity results in prices being observable with lower frequency (and thus at increasing intervals of time.)

Let us deal with the latter case within an option pricing context. But lets also do it simply. Well, lets at least try.

An option buyer has a right but not an obligation. An option seller or writer has the obligation but not the right. The option writer therefore has to hedge themselves for the possibility that they may have to perform under the obligation. The Black Scholes formula prescribes a hedging strategy, suggesting at any given point in time, the amount of cash (a negative amount, thus borrowing) and underlying instrument in the correct proportions, so that the option obligation is hedged. Since these proportions vary with the cost of borrowing and the underlying price level, there is significant trading involved in maintaining a hedging position. With trading comes trading costs. Even assuming away transaction costs, there will be a profit or loss generated from the trading activity. Hedging an option always generates a trading loss since one is continuously buying high and selling low. Crudely, the more volatile is the underlying, the larger the trading loss. The higher the interest rate, the more costly it is to hold the static hedging position. If one regards the option premium as the cost of hedging it and thus the trading cost plus carrying cost, the higher the interest rate, and the higher the volatility, the higher the price of the option.

Let’s concentrate on the volatility aspect. Volatility is by far the most important factor in pricing an option. So much so that options are often quoted in terms of implied volatility. We know that option prices are an increasing function of the underlying volatility. This is true under all established option pricing models continuous time processes to those which admit discontinuities.

Recall that we assume that the underlying volatility is unchanged but that we now vary the liquidity of the underlying market. This is modeled by varying the interval between transactions and thus price observation. The less liquid is the market, the longer the interval between observations.

The longer the trade interval, the more costly will be the trading cost of hedging since one cannot execute at the prices one wishes to. The cost will vary as an increasing function of the maximum possible gap or jump in the price of the underlying across intervals. It is not dependent on the actual size of the jump or on some probability adjusted size of jump. For the hedger, they must have some idea of the maximum possible jump. Now for a given volatility, the maximum possible jump size is a function of the length of the interval. Luck may result in a price mean reverting within the interval but as one cannot observe it, and one cannot rely on luck, the maximum jump size is an increasing function of the size of the interval.

Thus, the less liquid is a market, the larger the trading intervals, the larger the maximum possible jump and the larger the trading cost in hedging an option on the underlying. The larger the trading cost implies the larger the premium or the price of the option.

We now make a leap in transitioning from the option to underlying by noting that the underlying is a zero strike option on itself, assuming prices can never be negative. Even without this leap we can make our next observation.

Liquidity can be priced in implied volatility spreads. While an absolute level may be hard to obtain, we can obtain some notion of price for an instrument trading under liquid versus illiquid conditions. The details I leave to the mathematicians among us.

One can imagine using this methodology to price the value of having monthly versus quarterly liquidity in hedge funds for example. Already volatility is a factor for sorting and ranking hedge funds in a mean variance framework. This is the Sharpe Ratio. One can think of a Liquidity Adjusted Volatility leading to a Liquidity Risk Ratio which measures Return over Risk free divided by Liquidity Adjusted Volatility.

One simple application of this methodology is in pricing liquidity in different liquidity classes of the same fund. Since returns and volatility are the same, one would like to decide whether to invest in the less liquid class in return for a discount in fees. Now you can quantify it.

During the Asian Crisis of 1997, the Malaysian equity market fell initially by over 60% in from early to late 1997. It then rebounded by nearly 50% in early 2008 before falling another 60% for a total drawdown of some 76%. In Jakarta, the initial loss was 57%, the bounce 73% the subsequent fall 53% for a cumulative loss of 65%. In Hong Kong stocks fell 46% then rallied 34% before falling 40% for a total drawdown of 58%. In Singapore the initial loss was 39%, the bounce 36%, the subsequent loss 42% for a cumulative return of -52%.

Since then those markets have recovered and the economies rehabilitated themselves. 

Since their highs in 2007, the FTSE lost 46% in the initial fall, rebounded 28% from Sep 2008 lows to Dec 2008 before falling to a new low in March, the Eurostoxx fell 45% to Sep 2008, rose 30% to Dec 2008 then fell 27% to March 2009, the S&P500 fell 36%, rose 30%, fell 27% before rising 23%.

The psychology of crashes and recoveries is that initially, investors take leave of their senses and the market rises to some highly overvalued level unsupported by fundamentals. Something happens to burst the bubble and once again investors take leave of their senses in an avalanche of panic selling. Markets fall precipitously to levels unreflective of fundamentals. That is not to say that fundamentals themselves are not rapidly evolving. Governments and regulators get involved in an effort to avoid systemic failure. Investors are at first skeptical and there is no market recovery. After a while, the new measures take hold but only slightly. Investors take leave of their senses in a wave of buying fueling a relief rally. The market surges beyond the paltry improvements in fundamentals. Repeat with less volatility until investors come to their senses and market prices come to reflect fundamentals a bit more closely.

The question is which one was the big relief rally? Was it the November, December 2008 rally or the March 2009 rally? If it was November 2008, then the market low of March 2009 may have been bottom or close to bottom and the current rally is the start of a proper recovery. If the current March 2009 rally is the big relief rally, then it is likely to run out of steam soon, and the market will likely test the lows of March later this year. If it survives the test then we have the beginnings of recovery. If it barrels through to a new low, then the bear market is alive and well and new levels of support will need to be formed and tested.

The reality of the fundamentals is that things will not improve for some time yet. The first quarter 2009 results are not going to be positive, how can they be? The market has either discounted them or not. That is a matter of psychology. As for the medium term fundamentals, unemployment is on a trend with considerable momentum, trade is also on a downtrend, the various rescue plans of the US government are not very detailed and at best fail to address a number of important issues, are a supply side solution without addressing demand side problems and the outlook for economic growth is at best highly uncertain. Things could improve quickly with the volume of stimulus that has been applied, or they could simply muddle along. The point is that with volatile fundamentals, it is impossible for the market to price them.

The market is therefore likely to be a trading market driven by sentiment more than fundamentals. Direction is therefore dependent on the weather.

Later in the year, I expect we will have more clarity either way. It could be worse or it could be better. I hold with the optimists. Nothing lasts forever, not bull markets and not bear markets.