Saturday, 26 July 2014

Fruity carry filtering

18:29 Posted by The Thalesians (@thalesians) No comments

Later, I am due to attend George Cooper's Thalesians talk in Budapest on his new book Money, Blood & Revolution. In the meantime, I am supposed to while away the hours. I should be adept at doing very little. Unfortunately, whiling away hours is something which I am ill suited to. I always have to be thinking or writing or analysing. Perhaps, an inability to do nothing, suggests a long holiday is necessary soon. Maybe it is the human condition to desire peace, but once peace comes to desire work or maybe it is just me?

In an event to soak up these free hours, I am sitting in Budapest's central market hall (Nagy Vasarcsarnok) which is punctuated by many various stalls and is pictured above. My eyes intermittently rest on this iPhone's screen, in between brief seconds when they glance at the market, my fingers tapping away these words. Around me some stalls specialise in Hungarian pastries, such as retes, a type of strudel, which I advise sampling. Other stalls are butchers, whilst much of the rest are green grocers, displaying all manner of fruits and vegetables. Whilst some of these stores are nearly identical to their neighbours, somethings are certainly different: the number of customers they are serving.

Some of the shopkeepers seem to be staring into the distance, somehow hoping for a customer to drift past and show interest. Other stalls seem persistently busy, with customers continaully swarming their stalls. When the foot flow picks up, all the stalls seem busier. I imagine towards the end of the day, there will so little footflow, even the busier stalls will become quiet.

In a sense, this market is not very different to financial markets. We have sellers (the stalls) and we have buyers (the customers). When markets are buoyant, investors are less discriminatory. They simply want to hunt for yield. At present, we are in the situation where there is large foot flow nearby all the stalls selling "high yield". Indeed on finance based Twitter a lot of commentary has been dedicated to this topic (in somewhat tongue in cheek fashion).

Whatever has yield, regardless of the fundamental story seems to be bid. To some extent we see this today, where all sorts of names are issuing debt. The challenge is not to know who has raised debt, rather it is to know who hasn't been raising debt!

The question is of course, how long will this last? I would love to give you a perfect prediction! From a quant point of view this notion of being able time "risk" trades is something that all of us wish to do. In FX, this amounts to trying to model FX carry returns. We want to predict when the music will stop playing to somewhat paraphrase Chuck Prince (NYTimes: Citi Chief on Buyouts: ‘We’re Still Dancing’ 10 Jul 2007). When will all the carry stalls be "popular" and conversely when will they not? Some solutions are less satisfactory than others.

The idea that we can develop a perfect filter which avoids FX carry drawdowns during periods of poor risk appetite, seems too good to be true. I would argue that it is! Yet, that does not mean we cannot mitigate the impact of drawdowns via a carry filter and have something less than perfect.

I would argue that the key problem with risk filters is how they are implemented, rather than the concept of using a filter. If your filter has too many false signals it will perversely make you end up worse off than running no filter at all. You can end up being caught on the wrong side of risk sentiment repeatedly with a poorly designed filter. Furthermore, how should the filter actually be traded? Should a carry filter be a simply on/off switch? Or should it be more progressive?

Just because we cannot predict Black Swan events, it does not mean we throw up our hands and do absolutely nothing to at least try to reduce their fallout when they do indeed happen. In the case of FX carry and indeed many high beta exposure, a risk filter can help to reduce (but not eliminate) drawdowns. Just make sure you design it carefully and are able to avoid some of the pitfalls associated with risk filters, which I have discussed.

Perfection is impossible in any market, but less than perfect can just about be good enough in trading.

This was written before George's Budapest talk at the Thalesians, which took place on Friday 25th July. I shall be writing a bit more about his talk and book soon on the blog!


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