Black swan, USD swap and Risk Parity (parody?)

Let’s take a breather today and talk less on markets and talk more on where we are in this “Black swan” event.

By the way the more I understand about the heightened volatility there are two major contributors apart from all the algorithm-based positions that had to be unwound.

In stressed situations like this money does not flow the way it should. The situation was the same in 2008. Central banks must step in with unusual urgency and measures to ease the situation.

Smart hedge fund managers who sense this arbitrage opportunity also make a lot of money. If anyone can remember, George Soros made a lot of money in the currency markets during the GFC as he knew better than anyone how the currency markets will play out. It was a short-term opportunity.

Though the Fed and other central banks have taken massive monetary and fiscal measures it has not played out smoothly in the markets. The Fed is continuing to battle to stabilize the Treasury market. They had to reopen dollar swap lines with central banks around the world yesterday.

Here’s how it works. The Fed agreed to give USD to foreign central banks at a determined exchange rate for the currency of the respective foreign country. And when the swap ends, the two central banks simply repay the same quantity of currency back. There’s no exchange rate risk and no impact on the demand for currency in the open market.

The stress in the cross-currency swaps have been so much that in some currency pairs it has been costing more than ten times the normal rates. The stress is all due to trust issues between counter parties and only central bank intervention can ease that situation and bring order.

The other issue is some of the world’s biggest hedge funds are into a program called risk parity. There are mainly five major hedge funds that have been very active on this program. It is a version of modern portfolio theory also known as mean variance optimization. But different.

In an ideal world, risk parity gives superior returns on a risk adjusted basis. The key is in the management of risk. It is a play of leverage, volatility and non-correlation. In a way these strategies were collecting pennies in front of a steam roller. Only a Black swan event could stop them from making money and that happened.

In a world when everything is correlated, and liquidity is fully dried up the door becomes too narrow to get out. Volatility shoots through the roof. As these hedge funds are governed by their own internal risk parameters and promises to their customers, they are forced to get out of the positions when they breach certain limits. That has happened and has created the unbelievable volatility in the markets.

When you get to see their performances at the end of the month there must be some real horror figures.

Now to other matters.

Since we have been thrust into this depressing situation emotionally, physically, financially and economically by this virus what has the health authorities and government been doing for markets and society.

There has been a significant ‘rate of change’ in the situation. We have moved from no plan, to a plan with hope and that’s good news.

The encouraging treatment options for the virus has not been addressed that publicly. This is likely by design, as they’ve been campaigning to build enough concern among the population, so that they comply with recommendations to ‘lay low’.

But yesterday POTUS along with the FDA commissioner let the public know about some treatments that have shown favourable results (anecdotally and in testing) in reducing the impact of the virus and increasing recovery times.

The most interesting drug with a low barrier to entry, is a drug called Hydroxychloroquine (a malaria and rheumatoid arthritis drug). This was the first option Trump mentioned yesterday. It’s an FDA approved drug but not yet for the treatment of coronavirus. The FDA is currently looking at the trials.

Meanwhile the bar for FDA approval is significantly lowered for serious rare diseases that have little to no treatment options. Their main concerns are safety and efficacy. Given the long history of the drug, it’s considered to be safe, but dosage is what they are studying now. Except this to get approved quickly for use in the US.

It has been used in China, South Korea, Japan and in Europe with anecdotal success. And there is research being produced on it, almost daily.

So, let’s be optimistic and enjoy our weekend.

Be safe.