Tuesday, September 29, 2009

Liquid risk strategies are highly correlated

What does the Australian dollar (AUD) have to do with global equity markets? Fundamentally at first glance not that much. Australian equity market cap is a small fraction of the global markets. But the data shows something else. The chart below shows the regression plot between AUD and the MSCI World Index (global equity index) since Sep-08. The R^2 for the regression is 0.75, pointing to the fact that a large part of AUD/USD movements are explained by the global equity markets. One gets a similar result for the AUD/JPY cross.

AUD/USD vs. the MSCI World Index

source: Bloomberg

In contrast however, Dollar/Yen shows little relationship to the global equity markets (see chart below).

USD/JPY vs. the MSCI World Index

source: Bloomberg

What's going on here? What's so special about our friends down under? It turns out that it has less to do with Australia and more to do with correlated risk taking. We discussed this before in the context of the "carry trade".

Imagine the global markets as continuously jumping in and out of liquid risk trades. A risk trade is anything that produces positive returns when we have an "all is well for now" feel around the world. If no scary things happen a risk trade should do well, but as soon as something spooks the markets, the risk trade gets unwound. That's why it needs to be liquid.

The two most liquid risk trades are global equities and currency carry trades (long a currency with high interest rate and short a currency with low interest rate). We all know why equities represent a risky trade. The carry trade is also risky because it tends to be highly leveraged. Some may argue that commodities are in that camp as well, although liquidity there is not as high (relative to currencies and equities). That means that when traders put on risk, some go long equities, others put on the carry trade. When they jump out, the reverse happens. The key is that they do it simultaneously (usually it's different sets of people who trade these). That's why the correlation works for AUD/USD and AUD/JPY - both of these are a high rate currency against a low rate currency, i.e. carry trades. USD/JPY is not a carry trade, thus the correlation to equities is insignificant.

The lesson here is simple: if you have liquid risk strategies, expect them to be correlated, no matter what the asset class is. That is why those who think diversification will significantly cut their risk are surprised every time when seemingly unrelated markets/strategies become correlated.

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