It's All About Me

Time for some self-promotion.

I have written a fair bit about announcements, market expectations, and using scenarios for risk management (as well as ranking mutual funds). Here are some currently active links to my work.

• Credit Downgrade/Fat Tails/Mixture of Normals - It is February 17, 2000, and Moody’s Investors Services has placed on review, for possible downgrade, the Aa1-rated yen-dominated domestic securities of the Japanese government. Moody’s called the review because Japan’s Ministry of Finance forecast its national debt to exceed 129% of its GDP at the end of fiscal year 2000. Moody’s last downgraded Japan’s debt because the ratio had reached 100%. Japan’s current debt-to-GDP ratio is the highest among all industrialized nations. Apart from extraordinary events such as wars, this level of debt is unusual. A story about how risk managers at a fictitious US bank with a large position in Japanese government bonds deal with the implications of the downgrade for their portfolio.

• Interest Rate Forecasts as Scenarios - A risk manager at a fictitious US bank is asked by a board member who had seen a survey of forecasts for interest rates at the end of the year asked, “What might the banks’ losses be if these forecasts represented the mainstream opinion, but everyone was wrong?” This story investigates ways in which forecasts can be used to create scenarios for risk analysis.

• Economic Announcements and Risk Measures - This story investigates whether knowledge of an impending policy announcement by the Federal Reserve Board (Fed) is useful in estimating market volatility, and therefore risk. Risk measures based on a variance-covariance matrix derived from recent historical data assume that history is stable and will repeat itself. Information about an impending change in the target federal funds rate can be incorporated into a risk management framework through scenarios. Scenario-based risk measures capture the announcement effect, the higher volatility observed following a change in the federal funds rate.

• Earnings Announcements, Volatility Spikes and Risk Measures - It’s October 12, 2000 and there is a strong possibility that Microsoft’s release of its quarterly earnings on October 18, 2000 might miss Wall Street’s earnings expectations of $0.413. A broker whose largest portfolio consists of Microsoft stock, wants to ensure that its equity trading desk is accurately measuring risk. Its risk managers are aware that markets seem to show irregularities during a two-day period each quarter. If this phenomenon coincides with a downturn in Microsoft’s earnings, volatility might spike. Future volatility estimates based on this transient spike will be biased. This story examines the question: Is there a way to account for these shocks so they do not corrupt forecasts of risk measures for months to come?

• Scenario Banks and The Implications of Bank Takeovers on their Stock Price - On January 26, 2001, The Royal Bank of Canada (RBC) announces a takeover of Centura Banks Inc. in the United States. How can history be used to create scenarios to model RBC’s share price following the announcement of the takeover that will help an investor understand the implications of this news?

• How Bad is Bad News; How Good is Good News? - The stock market is driven by news. Good news lifts the market. Bad news dampens growth. Good news does not lift the market as much as bad news depresses it. Also, bad news during a bear market has a bigger negative impact than bad news during a bull market. To illustrate these two asymmetries in stock market, GARCH volatility models are estimated. Because volatility is unobserved, models for volatility are particularly difficult to validate. Our models are re-cast in terms of how they react to news. By applying news scenarios, the adequacy of the models can be assessed.

• Mutual Fund Ranking System – Developed for www.globefund.com, Globefund 5-Star Ratings service, a simple rating for most mutual funds in Canada. Globefund 5-Star Ratings help investors understand how well each fund has been doing relative to similar funds. Funds are ranked from one to five stars, with the top ranked funds getting five stars and the lowest ranked funds getting one star. While past performance does not guarantee future performance, our historical testing of this rating system has shown that on average, top-rated funds have tended to outperform their peers over a six-month to two-year horizon. Press release link.

• Stress test proves blue chips tops for returns, safety – (The Globe and Mail Print Edition 20/01/01 Page N2, Rob Carrick) To gain some insight into how the a couple of stock-picking strategies hold up in market declines, I looked at what would happen to both the TSE 300 and a couple of portfolios if the average price-earnings ratio for TSE stocks were to fall by three different amounts. I did some further testing on the two portfolios by measuring its performance on days when the Nasdaq Stock Market plunges.

Don't forget thatI will be giving a presentation on the impact of news on financial markets to the Toronto Association for Business and Economics (TABE).

• Location: Bank of Montreal - BMO Boardroom, 21st Floor, 1 First Canadian Place, King St. West and Bay Street, Toronto (map)
• Date: Thursday April 5, 2007
• Time: 12 noon to 2 p.m.
• Cost: TABE and CABE members in good standing around $25-30, others $45-50. A light lunch will be available.
• Registration: Closer to the date you will be able to book on-line at: www.cabe.ca/chapters/TABE. Or you can call 905-845-3102 or E-Mail tabe@cabe.ca.
• TABE Members (only) may pay cash or cheque at the door, non-members and credit card payments (VISA, Diners/EnRoute, MasterCard, or American Express) are to be prepaid via the web site. No-shows will be invoiced. Charges include GST. (TABE GST number: R124389990).

Consensus Forecasts and Herd Mentality

This is the third and final note about a post by the FX guru of Nova Scotia, Tom Yeomans, entitled “Is news trading dead?”

Tom talks about how FX trading around economic announcements has changed over the last few years. He then outlines a view of the future of FX news trading that involves forecasting the announcement.

Since it is news (that is difference between the actual release and the market’s expectation just before the release) that moves the market you need not just a forecast but also a read on what the market thinks.

Tom discusses the use of consensus forecasts. He notes that “Usually they had 18-21 people making guesses. That always seemed a little suspect to me …”.

I have noted in another post about the problems with consensus forecasts.

However consensus forecasts can be made useful. In a paper on how forecasts can be used by financial institutions for risk management purposes I noted that surveys of forecasts can be used to develop scenarios for risk management and how …

“This allows risk managers to understand their potential losses conditional on a range of forecasts. The average forecast and the dispersion in forecasts can be used to build a model of the distribution of market participants' expectations. The fitted model can then be used to extrapolate to large moves and thereby address the problems of sparse and clustered data. Finally, conditional scenarios can be used to mitigate the lack of coverage in forecast surveys.”

Note that scenarios, based on forecasts, can also be used for speculating as well as risk management since the focus is on the entire set of possible outcomes and so scenarios paint a picture of the return and the associated risk.

Of course, for certain announcements getting a read on the market is easy since a full distribution of expectations can be had from auctions of economic derivatives.

Trading Scenarios

I’ve been thinking some more about a post by the FX guru of Nova Scotia, Tom Yeomans, entitled “Is news trading dead?” In a tremendously interesting and informative post, after chronicling the history, Tom outlines a view of the future of FX news trading.

He says that it seems now that he can’t straddle the market and he wants to avoid the chaos of the first few minutes after an announcement. As a result he says it is inevitable that he will have to make predictions of what the official numbers will be several hours prior to an important economic report. He suggests that a forecast within the framework of a money management system would permit the pyramiding trades early in the morning based on the assumption that we “know” what the economic report numbers will be. He goes on to suggest that this would more or less emulate the way a large brokerage or investment house would do it.

I agree. I think the most promising approach is to use range of outcomes (scenarios) conditional on a range of forecasts. This gives the likely return and the attendant risk associated with a particular position.

What would this look like? Well, right before certain big U.S. economic announcements we have the results of derivatives auctions that give us a very good view of the market’s expectation. The modeling that I have done links this expectation with market responses. For someone that is interested in the EURUSD following a non-farm payroll announcement, they might be interested the chart of the distribution of market expectations (link to example charts) and what the resulting return chart is for the EURUSD (example charts, and some more).

A Short History of News Trading

I’ve been thinking about a post by the FX guru Tom Yeomans entitled “Is news trading dead?” In a tremendously interesting and informative post Tom documents his experience in news trading as:

• 2003-4 Straddling – Traders would place an order 15 pips above and below current price 30 seconds prior to the release of an important economic report. No matter where price went, the trader would profit. Straddling worked well and brokers guaranteed fulfillment of the order.
• Whiplashing the Straddlers - My understanding is that in response to straddling, brokers increased spreads and took the waiting orders, then decreased the spread and filled the waiting orders, triggering stops all over the place seconds prior to the report being released. That move (called a whiplash) ended straddling.
• Tick trading - This trading exploited the delays in updating currency pairs.
• Delayed correlation signals – using the correlation of the USDCAD against the EURUSD to give entry and exit signals. Tom still uses the correlations but not the same way since the correlations are not as useful.
• News trading – Quote from “Is news trading dead?”: “When I first began trading economic numbers, I did it with B’berg on the web and constantly refreshing my browser or searching around for a feed that gave me them fairly quickly. I usually had a few minutes to place my trade, have it accepted, and then a few sips of coffee before it began to move. That was on the EURUSD in 2006. It often took up to 20 minutes before the UK based reports moved the market. I am dead serious.”
• News Arbitrage - Summer 2006 - thousands of people, faster entry, special brokers, and software began to scalp the market immediately after a report. As a result the spreads have widened prior to big reports. Mr. Yeomans might be somewhat responsible for this as he has been successfully training people to trade the news for some time.
• Wait and see – Tom now sets his triggers higher knowing that noise created by people jumping in and out during the first minute creates chaos. These days, Tom waits to see confirmation of the move in a clear, sustained direction. By waiting an extra minute or so to see the move going in the correct direction means that he can execute his trade when the spreads have dropped back to normal. The idea is to still base the trade on the economic numbers and results, but to increase the lot size of the trade while forfeiting the early gains of the move. By placing larger bets he hopes to get the same payoff as before news trading became so popular.

Tom has adapted to market conditions and continues to do so. Next I’ll discuss Tom’s view of the future of FX news trading and how I think it can be realized.

See Me Perform - Live and In-Person

This is an early warning that I will be giving a presentation on the impact of news on financial markets to the Toronto Association for Business and Economics (TABE).

• Location: Bank of Montreal - BMO Boardroom, 21st Floor, 1 First Canadian Place, King St. West and Bay Street, Toronto (map)
• Date: Thursday April 5, 2007
• Time: 12 noon to 2 p.m.
• Cost: TABE and CABE members in good standing around $25-30, others $45-50. A light lunch will be available.
• Registration: Closer to the date you will be able to book on-line at: www.cabe.ca/chapters/TABE. Or you can call 905-845-3102 or E-Mail tabe@cabe.ca.
• TABE Members (only) may pay cash or cheque at the door, non-members and credit card payments (VISA, Diners/EnRoute, MasterCard, or American Express) are to be prepaid via the web site. No-shows will be invoiced. Charges include GST. (TABE GST number: R124389990).

NFP FX Correlation Matrix

It is not news that news moves financial markets. This blog will publish research on how, when, why, and which news moves what financial markets.

On Monday, November 06, 2006 in a post entitled “Recent Developments in How Economic Announcements Affect Financial Markets” I noted that the EUR and the CHF move in opposite directions when the U.S. trade news is announced. I expanded on this in the post on Wednesday, December 27, 2006, “Hidden Relationships” noting that the Swiss Franc and the Euro also appear, on average, to move in opposite directions to the U.S. Dollar when non-farm payrolls are announced.

Then on Friday, January 26, 2007 in "More Hidden Treasures" I looked at how the Yen and the Pound appear, on average, to move in opposite directions to the U.S. Dollar when non-farm payrolls ("NFP") are announced.

These NFP relationship can be encapsulated in a correlation matrix for foreign exchange returns right after the news. Here is the NFP return correlation matrix 1 minute after the announcement:

Announcement	NFP
Minute	1
	AUD	CAD	CHF	EUR	GBP	JPY
AUD	1	-0.8692	-0.925	0.9432	0.9136	-0.8767
CAD	-0.8692	1	0.8232	-0.8417	-0.832	0.7753
CHF	-0.925	0.8232	1	-0.9901	-0.9688	0.8832
EUR	0.9432	-0.8417	-0.9901	1	0.9655	-0.889
GBP	0.9136	-0.832	-0.9688	0.9655	1	-0.9016
JPY	-0.8767	0.7753	0.8832	-0.889	-0.9016	1

I have highlighted the correlations previously discussed. But as one can see there are other interesting leverage/hedging opportunities. Note that all of these correlations are significant. The 5% critical value(two-tailed) = 0.2787 for 50 observations (monthly data from Nov 1 2002 i.e. October 2002 release to Dec 8 2006 i.e. November 2006 release). If anyone would like a spreadsheet of my calculation of the 1, 5, 10, 20 and 30 minute return correlation matrices for the U.S. announcements of nonfarm payrolls, initial jobless claims, retail sales, and CPI, please send me an email to john.parkerATrelevanteconomics.com.

Retail Sales Correlations

t is not news that news moves financial markets. This blog will publish research on how, when, why, and which news moves what financial markets. It is important to know how different currency pairs move in relation to each other to manage portfolio exposure. Some currency pairs move together, while others move in opposite directions. Whether you are looking to hedge, diversify your positions, or find alternate pairs to leverage your view, it is important to account for the correlation between various currency pairs. In the last post I suggested that for those looking at economic announcements return correlations using data from announcement days are the most useful. Here is a set of correlations for the Retail Sales (ex-autos) announcement in the U.S. for the most traded currencies.

Calculated:	Feb 6 2007
Data From:	Feb 13 2001 (January 2001 release)
Data to:	Dec 13 2006 (November 2006 release)
Announcement:	Retail Sales (ex-autos)
By:	John C. Parker
	1-minute return correlation
		Correlation Coefficients, using the observations 1 - 71
		5% critical value(two-tailed) = 0.2335 for n = 71
	AUD	CAD	CHF	EUR	GBP	JPY
	1	-0.6816	-0.7672	0.7755	0.759	-0.707	AUD
		1	0.7193	-0.6596	-0.6659	0.5896	CAD
			1	-0.9635	-0.9051	0.8233	CHF
				1	0.9212	-0.847	EUR
					1	-0.79	GBP
						1	JPY
	5-minute return correlation
		Correlation Coefficients, using the observations 1 - 71
		5% critical value(two-tailed) = 0.2335 for n = 71
	AUD	CAD	CHF	EUR	GBP	JPY
	1	-0.632	-0.7237	0.7075	0.7452	-0.657	AUD
		1	0.6061	-0.6044	-0.5514	0.5866	CAD
			1	-0.9829	-0.9056	0.8347	CHF
				1	0.9092	-0.84	EUR
					1	-0.845	GBP
						1	JPY
	10-minute return correlation
		Correlation Coefficients, using the observations 1 - 71
		5% critical value(two-tailed) = 0.2335 for n = 71
	AUD	CAD	CHF	EUR	GBP	JPY
	1	-0.6801	-0.6913	0.6974	0.6813	-0.703	AUD
		1	0.5742	-0.5811	-0.4945	0.6132	CAD
			1	-0.9812	-0.8691	0.8178	CHF
				1	0.895	-0.807	EUR
					1	-0.736	GBP
						1	JPY
	20-minute return correlation
		Correlation Coefficients, using the observations 1 - 71
		5% critical value(two-tailed) = 0.2335 for n = 71
	AUD	CAD	CHF	EUR	GBP	JPY
	1	-0.6915	-0.7418	0.7805	0.7476	-0.627	AUD
		1	0.58	-0.6022	-0.5234	0.5736	CAD
			1	-0.9757	-0.8799	0.6684	CHF
				1	0.8931	-0.678	EUR
					1	-0.694	GBP
						1	JPY
	30-minute return correlation
		Correlation Coefficients, using the observations 1 - 71
		5% critical value(two-tailed) = 0.2335 for n = 71
	AUD	CAD	CHF	EUR	GBP	JPY
	1	-0.6505	-0.7858	0.8068	0.7017	-0.642	AUD
		1	0.5347	-0.525	-0.4108	0.4609	CAD
			1	-0.9738	-0.844	0.7219	CHF
				1	0.8651	-0.706	EUR
					1	-0.649	GBP
						1	JPY

AUD/USD - Australian dollar USD/CAD - Canadian dollar USD/CHF - Swiss franc EUR/USD - Euro GBP/USD - British pound USD/JPY - Japanese yen