Toward a global risk map

Now I’m quite involved now with trading and coding so I have little time to write posts. But today in the very morning a read a very interesting BIS paper written by by Stephen Cecchetti, Ingo Fender and Patrick McGuire.(Link here)Authors wants to build a giant global risk monitoring system which would monitor risks not only on macro level but also will monitor feedbacks between funding and asset side of financial institutions. This will be another important step in understanding functioning of global financial system

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Analyzing Interconnectivity among Economies

Complecixty of the global financial system first became so obvious when the Lehman Brothers collapsed in 2008. A complex wave of feedback loops which the collapse has generated was far beyond expectations and far more disastrous than classic economic/risk models were suggested. Since then there is growing number of economic papers focused on how the economic network topology, interconnectivity, etc contributes to economic stability. Here you can find to link to Alfred Wong and Tom Fong paper. This study focuses on CDS spreads of 11 Asia Pacific economies and its interactions. A major finding is that all these economies register a significantly higher sovereign risk once the condition that another economy is in distress is imposed.

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Credit – another dimension of commodity trade

Amid mounting fears of debt crises in Europe (or more generally sovereign debt around the world) commodities are seen as safe haven. This consensus might be misconception as market participants could miss several points.

• First point is (but possibly lest important) the fact that “FEAR” is not an equilibrium concept
• Secondly demand and supply curves may not be independent the demand and supply is not guided my current prices but rather by future prices.
• My last but not least important point is that the futures markets heavily depend on credit market. As I mentioned earlier the supply and demand curves may not be independent (even in case of commodities) as financial intermediaries adjust actively their balance sheets to their VAR models (pro-cyclical). In other words greater demand for the assets tends to put upward pressure on its prices, and then there is a feedback effect in which stronger balance sheets feed greater demand for the asset which in turn raises the asset price and lead to bigger balance sheets ( for more detail analysis of this process please look on the one of the previous post or read Shin and Adrian paper ). This process if unchecked can lead asset prices up to the sky and then down to the hell. At climax of this process utilization of collateral is at full and the price is strongly dependent on further and faster credit inflow which amid rising LIBOR rates may be difficult.
  
  Chart above shows swap positioning for US copper futures (The Spreading: For the futures-only spreading measures the extent to which each non-commercial trader holds equal long and short futures positions. Non- commercial traders are not involved in an underlying cash business; thus, they are referred to as speculators). It clearly shows that copper prices are strongly affected by speculative activity and are heavily dependent on credit market. This I just one example but cross-correlation of metals is high and all commodity markets looks similar. As I wrote previous post I think we just get into unstable phase.

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Note on log-periodic description of 2008 financial crash

Here you may find link to short paper of Katarzyna Bolonek-Lason and Piotr Kosinski. This another example of implementation of LPPL for detecting a critical state of market

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Do bubbles lurk in metals?

Sugar bubble has burst. Analysis posted earlier on this blog was correct but... it was not accurate enough to make money out of it.

Now again I’m turning my attention to commodities but this time to metals as my intuition tells me that the bubble may lurks in there. My intuition is driven by increasing cross correlation of base and precious metals. This time on top of estimating LPPL I also plan to implement Minimum Spanning Tree (MST) to get more insight in to the metal markets topology. This project is partially inspired by Paweł Sieczka and Janusz Hołys research paper (link here).

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Empathy, bubbles and mistake of Polish monetary policy

“Investors are concerned, not what an investment is really worth, but with what the market will value it at…three months or a year hence”…”We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be and there are some, I believe, who practice the fourth, fifth and higher degree”

J.M.Keynes , The General Theory of Employment, Interest and Money (1936 London page 152)

Keynes paid a great attention for market psychology and higher orders expectation. In his “General theory…” he compares asset markets to a beauty contest where participants have to chose the faces that other competitors find the most beautiful. His beauty contest may be also helpful in understanding uncovered interest parity failure.

Speculative capital moves in search of the highest total return. Let’s assume for simplicity that the total return has two elements: the interest rate differential and the return on exchange rate appreciation. In words to make money you should borrow in low yielding currency i.e. USD and put deposit in high yielding currency i.e. PLN (Polish zloty) and pray for exchange rate to depreciate slower than the interest rate differential.
Classical economy claims that uncovered interest parity (UIP) holds and expected future exchange rate is equal to the interest rate difference. Meaning that higher yielding currency should depreciate faster, flattening out the possible profit. But classical economy assumes that the valuation process is passive whereas the capital inflow is motivated primary by expectations about future exchange rates.

If sufficiently large group of investors expect that the market will value the high yielding currency too high next period, they will buy it pushing exchange rate down vs. lower yielding currency. This self validating process will be in place as long as capital will continue to flow in and as long as there will remain investors non confident in appreciation of high yielding currency.

This expecational error has finite time singularity where the crash probability is highest. Nowhere is Keynes beauty analogy more relevant than in the characterization of the crash hazard rate, because the survival of the bubble rests on the overall confidence of investors in the bullish trend.

In that view bubbles are result of positive feedback among investors and imperfect information processing. LPPL model developed by D.Sornette is just a tool which is designed to catch the coordinated swing in market opinion. I will not here describe it again ( you my find it in Sornette papers or in my presentation about sugar bubble)

Here I want to concentrate on macro signs/”fingerprints” of positive feedbacks which leads to bubbles and crashes.

Below charts show some stylized facts of EUR/PLN exchange rate fluctuation. I cut the whole decade (1999-2010) into 5 periods (3 bubble formation periods ( I 1999-2001, II 2004-2008, III 2009-2010,)and 2 – anti-bubble / crash periods).

It’s clear in the charts below that every single period of rapid appreciation of PLN (and failure of Uncovered interest parity ) was triggered either by large FDI flow or expectations of future FDI inflow (or both). The first chart indicates that FDI inflow was the initial seed for the bubble which triggered self-reflective capital inflow expectations.

Self-reflective character of speculative inflows is well visible on the second chart (blue line). In 2004 portfolio inflow was not only constant but was even accelerating along zloty appreciation ( the stronger zloty was the more was demanded). This may suggest supply and demand curves were not independent but self-reflective.

Again same situation we could observe most recently. Large interest rate differential between Polish and US rates and expected large FDI inflow created initial bias in expectations for zloty appreciation. This was followed by portfolio inflow which to keep zloty appreciate has to accelerate. This is well visible in the fourth chart which shows that at the beginning of the year inflows were become stronger as foreign holding of Polish treasury bonds jumped to record high level.

The charts also suggest that most recent rapid appreciation of PLN was feed by foreign buying of Polish treasury bonds. To keep zloty appreciate the inflow had to be not only continued but also accelerate which amid PIIGS crises was unlikely. This finding supported LPPL estimation results which indicated that the exchange rate went into “critical” period. But as I said in the previous post the full inflating of the bubble is rather unlikely as only half of this year expected FDIs has been executed.

One period which especially needs attention is period between mid 2007 and end of 2008. For me this period is so important because the bubble which was created then triggered most rapid deprecation of polish local unit ever. What stands out is that at that time Polish monetary policy remained firm on tightening (interest rates up) course (inflation fears) despite the fact that the US monetary policy stance has been changed and also ECB was became dovish at this time suggesting that interest rate cuts were in the pipeline. Very high interest rate disparity and large FDI inflows generated initial bias for PLN appreciation. Because stance of local monetary policy at that time was still hawkish the speculative capital was not flowing through portfolio window (Treasury bonds priser are falling when the interest rates are increasing) but through short term FX instruments (options, SWAPS, Loans). Cumulative inflow to Monetary and Financial Institution (MFI) in that period of time top around EUR40bn!!! Polish exporters to withstand competition amid falling global demand started to buy EUR PUT PLN CALL FX options and financing the premium by selling EUR CALL PLN PUT FX options. As the chart is showing the stronger zloty the more it was demanded a clear self-reflective relationship. To keep zloty appreciate capital had to flow in even faster but process has singularity. Capital inflow slows down in mid of 2008, bubble has busted and a Polish corporations bankrupted as EUR CALL FX options were executed. It would be unfair to blame NBP MPC for that but its shows that inflation targeting framework has to be extended and financial stability has to be also targeted by central banks.

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worst preforming currency of the month - Polish Zloty (lucky me)

Polish zloty bubble has burst or at least we going through large bifurcation (more likely). A month ago I posted here a short note saying that the bubble is lurking in Polish zloty. At that time I also said that a more detailed analysis will follows however… Since then I was fully concentrated on trading trying building and executing strategy which would utilize findings of my research. Today I have closed EUR/PLN longs and option position. Now It’s time to celebrate but no later than on Monday I will post some short presentation with LPPL estimates for Polish zloty and some stylized facts

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