Copyright © 2018 T Leitch & J Liew
Agenda
- Global Macro
- Discretionary Manager Example
- Fundamental Models
- 4 Known FX Factors
- FX Manager Index
- FX Managers
- Analysis of Convertible Bonds
- Background Info on Convert Industry
- Convertible Arb
- Distressed Securities
Discretionary Global Macro
In my opinion, (discretionary) Global Macro is the hardest strategy to properly evaluate. Discretionary managers typically have thematic approaches to their investment process and express their views through a variety of instrument such as futures, options, and fx, across global markets.
Rethink Captilism
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Background: Pound was in the Europe’s ERM, Soros bet that the Pound could not remain within the system, his position made $1B on Sept. 16th, 1992 (short the GBP)
Global Macro Defined
- The most “flexible” investing process employing economic judgment to justify (huge) positions betting on short-term and long-term movements across global markets
- Managers tend to look for global dislocations employing “macro”-judgment in the attempt to capitalize on both expected and unexpected shifts across the “global” markets
- Some inputs:
- Judgment
- Behavior Finance (Over-/under-reactions)
- Global trade imbalances
- Business cycles
- Geo-political concerns
- Emerging economies
- Risk-based dynamics
- Energy and alternative sources
- Demography
Case Study: Discretionary Macro Hedge Funds
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Ex-PayPal’s Peter Thiel’s hedge fund Clarium captured: (1) USD dollar weakening in 2003, and (2) energy rally in 2005
Best and Worst Environments
Fundamental Models: Yardeni
Fundamental Models: FX Classics and Carry
FX Market Background
- Largest financial market, trades $4T (USD) per day
- Established in 1971, inter-bank or inter-dealer network
- Over-the-counter (OTC), transactions not conducted on exchange (i.e. not like NYSE/Arca, CBOE, CME, etc.)
- Largest volume of trading: London, England
- Other trading centers: New York, Tokyo, Zurich, Frankfurt, Hong Kong, Paris, and Sydney
- Trades 24 hours per day, 5 days per week
- No “inside information”
- Forex traded by: Consumers/Travelers(purchase foreign good/services), Businesses (repatriate exported-sales), Investors and Speculators (hedge funds), Commercial and Investment Banks (deposits/lending and prop), Governments and Central Banks (adjust to financial imbalances)
Good Resource: http://www.oanda.com/
FX Trader’s View
“EURUSD trades ½ pip wide, with $2M on ask and $4M on bid side.”
Buy EUR or “lift the offer” : Buy $1M EUR and sell $1,348,250 USD
Sell EUR or “hit the bid” : Sell $1M EUR and buy $1,348,200 USD
Base currency EUR, and quoted currency is USD
FX Classic Models
- Purchasing Power Parity (PPP) – “The Law of One Price” – In long run equilibrium exchange rates should converge to price ratios of identical baskets of goods assuming efficient markets and similar agents’ preferences, creation costs, frictionless markets, etc. Ex. Economist PPP “Big Mac” Index http://www.economist.com/content/big-mac-index
- Covered and Uncovered Interest Rate Parity (F forward rate, S spot rate)
- Covered (Pure Arbitrage) —- \((1+R_{(USD)}) = [F/S]*(1+R_{(FC)})\)
- Uncovered (Expected Arbitrage) —- \((1+R_{(USD)}) = [E(Š)/S]*(1+R_{(FC)})\)
- F: Forward Rate; S: Spot Rate; E(Š): Expected Future Spot Rate
- What factors drive FX?
- Interest rate differentials – e.x. “Carry-Trade”
- Real economy strengths/weaknesses
- Expected Inflation
- News that affects above
- Monetary policy/Flow of funds
Always remember the easy decomposition:
\[(R_{(USD)} – R_{(FC)} ) = (I_{(USD)} + r_{(USD)} ) – (I_{(FC)} + r_{(FC)} ) =\]
\[(I_{(USD)} – I_{(FC)} ) + (r_{(USD)} - r_{(FC)} )\]
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FX Carry : “Sort currencies into highest to lowest yielding currencies, buy the top and sell the bottom (Yen).”
G10 FX Carry
So, create an ETF/ETN out of it…
DBV – Deutsche Bank’s G10 Harvest Fund Carry ETF
ICI – Barclays Intelligent Carry Index (G10 currencies)
FX Carry vs Equity-Factors
Active FX Managers Examined
* First,
Let’s examine and index of actively managed currency hedge funds:
Barclay Currency Trader Index (BCTI)
Theoretical Motivation
Assume an APT multifactor model: \[R_{t} = \alpha + \Sigma_{i}\beta_{i}F_{i,t}+\epsilon_{t}\]
FX Four Factors Identified
- Carry DB Harvest / Citibank Beta1
- Trend-following (32, 61, 117 days) moving average
- Value +/-20% over/under PPP
- Volatility EURUSD & JPYUSD / 3-mon. Imp. Vol. 9 fx pairs (CVIX)
Factor 1: Carry
“Carry factor. We used the Deutsche Bank Currency Harvest G10 Index as the proxy for the returns of a carry strategy. This index reflects the return of being long the three high-yielding currencies against being short the three low-yielding currencies among the G–10 currencies. The index is rebalanced quarterly. Every quarter, the currencies are re-ranked according to their current three month LIBOR. The Bloomberg code for this factor is DBHVG10U.”
Factor 2: Trend
“Trend factor. We used the AFX Currency Management Index as a proxy for the trendfollowing factor.17 The AFX Index is based on trading in seven currency pairs weighted by their volume of turnover in the spot market, with returns for each pair based on an equally weighted portfolio of three moving average rules (32, 61, and 117 days).”
Factor 3: Value
“Value factor. We used the Deutsche Bank G10 Valuation Index as the proxy for the returns of a value strategy. To gauge relative value, Deutsche Bank prepares a ranking based on the average daily spot rate over the last three months divided by the purchasing power parity (PPP) exchange rate as published annually by the Organisation for Economic Co-Operation and Development. The Deutsche Bank G10 Valuation Index reflects the return of being long the three currencies with the highest rank (undervalued currencies) against being short the three currencies with the lowest rank (overvalued currencies) among the G–10 currencies. The Bloomberg code for this factor is DBPPPUSF.”
Factor 4: Volatility
“Currency volatility factor. We used the Deutsche Bank Currency Volatility Index as the proxy for foreign exchange volatility. This index is calculated as the weighted average of three-month implied volatility for nine major currency pairs (as provided by the British Bankers’ Association), with weights based on trading volume in surveys by the Bank for International Settlements. The Bloomberg code for this factor is CVIX. We used the first difference for this factor in Equation 1 because it is not a trading strategy. For the previous three factors, we used returns.”
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Next,
Let’s examine if individual currency managers’ crowd trades
How to measure if a trade is crowded?
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Analysis of Convertible Bonds
Follows: Fabozzi 5th Edition (2004), “Bond Markets, Analysis, and Strategies”
Convertible Bonds vs Exchangeable Bonds
Convertible bond is a corporate bond with an embedded call option that grants the bondholder the rights to convert the bond into a predetermined number of shares of common stock of the issuer
Exchangeable bonds, similar to a convertible bond, however, grants the bondholder the right to exchange the bonds for the common stock of a firm other than the issuer of the bond
Convertible Bond Terms
- Conversion Ratio – the # of shares of common stock that the bondholder will receive upon conversion (or exercising the call option)
- Upon conversion:
- Physical Settle – bondholder receives from the issuer underlying shares
- Cash Settle – bondholder receives cash value of the underlying shares
- Upon issuance of convert, issuer has granted the bondholder the right (but not the obligation) to purchase the common stock at the strike price: \[(par\,value\,of\,the\,convertible\,bond)\,/\,conversion\,ratio\]
- Conversion Value – the value of the bond if it is converted immediately \[Conversion\,Value\,=\,mkt\,price\,of\,common\,stock\,*\,conversion\,ratio\]
Exercise: Consider XYZ Convertible Bond
Maturity: 10 years
Coupon Rate: 10%
Conversion Ratio: 50
Par Value: $1,000
Curr. Mkt price convert: $950
Curr. Mkt price stocks: $17
Dividend per share: $1
The conversion price = ?
Answer
$1,000/50 = $20 (=Strike Price)
Background Info on Convert Industry
Academic Evidence
- Arshanapalli, Fabozzi, Switzer, and Gosselin (2004), Lain (2006)
- 70-75% of new issues are bought by hedge funds
- Agarwal, Fund, Loon, and Naik (2010)’s “Risk and Return in Convert Arbitrage: Evidence from the Convertible Bond Market”
- Document key drivers of convertible arbitrage(CA), namely: (1) “buy-and-hold” strategy and (2) “buy-and-hedge” strategy. Explains about 30-60% R^2
- Highlight importance of non-price variables such as market-wide events(e.g. LTCM) and the correlation of supply of CAs on performance
- Larger funds are more active in (2) vs (1), and more vulnerable to supply shocks
- Convertible arbitrageurs collectively are rewarded for playing the “intermediation” role
Convertible Arb
Converts: How to hedge?
What are the risks? Or how do you hedge each component? Interest Rate (bond) + Corporate Default Risk (health of issuer) + Call Option (delta)
One Convert Example
Security Description
Q: What is DHI or D.R. Horton?
Defn: Parity is the market value of stock shares if you converted now
Ex. (76.5697) * $10.49 = $803.216153, quoted as a percentage of par ($1000 or 100%), so you get “80.32” or 80.32% (= $803.216153/$1000)
Defn: Premium is the difference between convert price and parity as percent of parity Premium = (Bond Price – Parity) / Parity Ex. (107.678 – 80.3216153)/ 80.3216153 = 0.340586 or 34.06(%)
DHI 2 05/15/2014
| Issuer |
D.R. Horton Inc. (DHI) |
| Title of security |
2.00% Convertible Senior Notes due 2014 (CUSIP: 23331ABB4, ISIN: US23331ABB44) |
| Coupon |
2% (Semi-Annual) |
| Issue Amount |
$500M |
| Maturity Date |
May 15, 2014, subject to earlier repurchase or conversion |
| Interest Dates |
May 15 and Nov 15, beginning Nov 15, 2009 |
| Offering Price |
100% |
| Conversion Ratio |
76.5697 shares of issuer’s common stock per $1,000 principal amount of notes |
| Trade Date |
May 7, 2009 |
| Settlement Date |
May 13, 2009 (T+4) |
Cycles in the Convertible Arbitrage Performance
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Convert Classification Confusion, even among institutions-quality organizations…
Distressed Securities
Securities (typically bonds/bank loans) of companies that are in default or under bankruptcy protection, or headed for such a “distressed” condition
What do “Distressed” managers hold?
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The defining discretionary global macro trade was by George Soros in Sept. 16th, 1992, when he bet on the devaluation of the British Pound
