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WhitePapers 2016-12-22T17:57:37+00:00

Go to Managed Futures

Title:  Backward to the Futures: A Test of three Futures Markets

Overview: Normal backwardation, first discussed by Keynes (1923), (1930) and Hicks (1946), is a fee paid by a seller of a security to the buyer for the privilege of deferring delivery. It implies that a risk premium exists so that the futures price falls short of the expected future spot price. The reverse case, ‘contango’, implies that the futures price exceeds the expected future spot price. This paper applies tests for the existence of normal backwardation to daily closing prices on the Sydney Futures Exchange (SFE), London International Financial Futures and Options Exchange (LIFFE) and the Singapore International Monetary Exchange (SIMEX). By applying a series of tests after Kolb’s (1992) study of US commodities, it is found that few of the contracts studied consistently exhibit normal backwardation while many show evidence of contango.

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Title:  A Classification Study of Carbon Assets into Commodities

Overview: This paper explores the classification of carbon assets generally considered as commodities by examining the characteristics of carbon prices. We propose a carbon price model reflecting the characteristics of the prices. The empirical studies using EUA (EU allowance) futures prices traded on the European Climate Exchange show that convenience yield of EUAs violates the property of commodities in terms of negative correlations between convenience yields of EUAs and EUA prices. It corresponds to the characteristics of the model we propose. Next, we examine mean reversion and seasonality of EUA futures prices often observed in commodity markets using AR(1) model with an annual sinusoidal trend. We show that EUA price analyses reject the existence of mean reversion and seasonality. We also examine the conditional correlations between EUA different delivery futures prices, resulting in almost positive correlations which may hold the same shape of the term structure as contango. In addition, the empirical studies using EUA option prices traded on the ECX show that carbon prices behave unlike commodities but like securities in terms of volatility smile. These empirical studies may support the counter argument to the classification of carbon assets into commodities.

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Title:  Baltic Dry Index as a Predictor of Global Stock Returns, Commodity Returns, and Global Economic Activity

Overview: The goal of this paper is to show that the growth rate of the Baltic Dry Index (BDI) has predictive ability for a range of stock markets, which is demonstrated through in-sample tests and out-of-sample statistics. The documented stock return predictability is also of economic significance, as seen by examining the certainty equivalent returns and Sharpe ratios of portfolio strategies that exploit the BDI growth rate. In addition, the BDI growth rate predicts the returns of commodity indexes, and we find some evidence for joint predictability of stock and commodity returns in a system of predictive regressions. Finally, the BDI growth rate predicts the growth in global economic activity, establishing further BDI’s role in revealing a link between the real and financial sectors.

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Title: Benefits of Investing in Alternatives

Overview: In a time when the headlines are abuzz with the latest hedge fund failure and growing uncertainty in the financial markets, many investors are left wondering why anyone would ever invest in alternatives. The general public perception of alternative investments and the reality are very different. The purpose of this paper is to provide qualified investors an accurate description of the investment options available in the alternative universe. The intention is to provide accurate descriptions of the three most common alternative investment vehicles: Hedge funds, private equity and managed futures. More importantly, the goal is to provide investors the necessary foundation to help make informed decisions in their future investment allocations. This paper will address the basics of alternatives, outline the above-mentioned vehicles and the benefits of investing in them, define the underlying risks, and illustrate the importance of working with a professional to uncover the opportunities they present.

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Title: A Dynamic Analysis of Moving Average Rules

Overview: The use of various moving average (MA) rules remains popular with financial market practitioners. These rules have recently become the focus of a number empirical studies, but there have been very few studies of financial market models where some agents employ technical trading rules of the type used in practice. In this paper we propose a dynamic financial market model in which demand for traded assets has both a fundamentalist and a chartist component. The chartist demand is governed by the difference between current price and a (long-run) MA. Both types of traders are boundedly rational in the sense that, based on a fitness measure such as realized capital gains, traders switch from a strategy with low fitness to the one with high fitness. We characterize the stability and bifurcation properties of the underlying deterministic model via the reaction coefficient of the fundamentalists, the extrapolation rate of the chartists and the lag length used for the MA. By increasing the intensity of choice to switching strategies, we then examine various rational routes to randomness for different MA rules. The price dynamics of the moving average rule are also examined and one of our main findings is that an increase of the window length of the MA rule can destabilize an otherwise stable system, leading to more complicated, even chaotic behavior. The analysis of the corresponding stochastic model is able to explain various market price phenomena, including temporary bubbles, sudden market crashes, price resistance and price switching between different levels.

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Title: A Synthesis of Technical Analysis and Fractal Geometry – Evidence from the Dow Jones Industrial Average

Overview: The profitability of technical analysis has been investigated extensively, with inconsistent results. This paper seeks to develop new insights into the profitability of technical trading rules through a synthesis of fractal geometry and technical analysis. The Hurst exponent (H) emerged from fractal geometry as a means to detect long-term dependencies in a time series; the same dependencies that technical analysis should be able to identify and exploit to earn profits. Two tests of the synthesis are conducted using the thirty Dow Jones Industrial Average components. Firstly, the financial series are classified into three groups based on their H to determine if a higher (lower) H results in higher returns to trending (contrarian) trading rules. Secondly, the relationship between H and profits to technical analysis are estimated through OLS regression. Both tests suggest that the fractal nature of a time series explains a significant portion of the profits generated by technical analysis.

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Title: Annualized Volatility

Overview: In this research note, we compare S&P 500 volatility figures calculated with the popular “square-root-n rule” to volatility figures derived from time-aggregated daily returns and try to reconcile the differences with popular time-series models featuring serial correlation in returns or volatilities. We show that the deviations from the square-root-n rule cannot be explained with serial correlation in returns, rather with a GARCH model. We conclude that volatility figures annualized with the square-root-n rule should not be interpreted as accurate estimates for true annual volatility. The square-root-n rule is also not suitable to standardize volatility figures for reporting purposes.

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Title: Black Swans are Not that Black

Overview: Some researchers have recently criticized using the normal distribution for modeling stock returns. While it’s true that the normal distribution is inappropriate and leads to the extreme outliers, known as the Black Swans problem, other elliptical distributions allow addressing this issue. The Student’s t-distribution with 3 to 4 degrees of freedom and the Laplace distribution both can be used to largely eliminate Black Swans in daily returns. Both distributions are compatible with the modern portfolio theory. We also show that no single distribution is clearly preferred when describing periodic returns, but the Black Swans problem is not so acute when considering returns over holding periods longer than one month.

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Title: A Comparison of Quantitative and Qualitative Hedge Funds

Overview: In the last 20 years, the amount of assets managed by quantitative and qualitative hedge funds have grown dramatically. We examine the difference between quantitative and qualitative hedge funds in a variety of ways, including management differences and performance differences. We find that both quantitative and qualitative hedge funds have positive risk-adjusted returns. We also find that overall, quantitative hedge funds as a group have higher alphas than qualitative hedge funds. The out-performance might be as high as 72 bps per year when considering all risk factors. We also suggest that this additional performance may be due to better timing ability.

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Title: Can Commodity Futures be Profitably Traded-Quantitative Strategies

Overview: Quantitative market timing strategies are not consistently profitable when applied to 15  major commodity futures series. We conduct the most comprehensive study of quantitative trading rules in this market setting to date. We consider over 7,000 rules, apply them to 15 major commodity futures contracts, employ two alternative bootstrapping methodologies, account for data snooping bias, and consider different time periods. While we cannot rule out the possibility that technical trading rules compliment some other trading strategy, we do conclusively show that they are not profitable when used in isolation, despite their wide following.

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Title: A Quantitative Analysis of CTA Funds

Overview: Our research studies various properties of commodity trading advisors (CTAs) from a quantitative point of view. Our investigation is based on a commercial database of 549 funds and focuses on the period 1990 to present. Firstly, CTAs’ return distributions are analyzed and strong evidence of non-normality is found, stressing the need for portfolio allocation techniques which take into account higher-order moments. Secondly, relative persistence in return distribution parameters is studied. We find strong persistence for volatility, but fail to find significant persistence for average return or higher order moments. Thirdly, we review the major benchmarks available to the industry and build new benchmarks from our data-set. This allows us to infer the magnitude of various biases. We study homogeneity of 2 CTA subsets, namely trend-followers and non-trend-followers, and study the diversification possibilities in a CTA portfolio. In the second part of the study, we focus on linking CTAs returns with that of traditional assets. After showing that a buy and hold multi-factor linear model fails to explain CTAs returns, we point out the presence of option-like payoffs in CTAs return patterns. Trend-following CTAs exhibit straddle-like payoffs, while non-trend-followers’ return patterns that are reminiscent of a long call option. Lastly, using simple trading algorithms based on moving averages, we propose a linear market model in which factors capture the dynamic nature of CTA managers’ strategies. Our model leads to significant improvements over the classical model. Notably, we show that our model is able to closely replicate a broad index of CTAs for long out-of-sample periods.

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Title: A New Anomaly – Cross-section Profitability of Technical Analysis

Overview: 

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Title: A Dynamic Analysis of Moving Average Rules

Overview: The use of various moving average (MA) rules remains popular with financial market practitioners. These rules have recently become the focus of a number empirical studies, but there have been very few studies of financial market models where some agents employ technical trading rules of the type used in practice. In this paper we propose a dynamic financial market model in which demand for traded assets has both a fundamentalist and a chartist component. The chartist demand is governed by the difference between current price and a (long-run) MA. Both types of traders are boundedly rational in the sense that, based on a fitness measure such as realized capital gains, traders switch from a strategy with low fitness to the one with high fitness. We characterize the stability and bifurcation properties of the underlying deterministic model via the reaction coefficient of the fundamentalists, the extrapolation rate of the chartists and the lag length used for the MA. By increasing the intensity of choice to switching strategies, we then examine various rational routes to randomness for different MA rules. The price dynamics of the moving average rule are also examined and one of our main findings is that an increase of the window length of the MA rule can destabilize an otherwise stable system, leading to more complicated, even chaotic behaviour. The analysis of the corresponding stochastic model is able to explain various market price phenomena, including temporary bubbles, sudden market crashes, price resistance and price switching between different levels.

>>> Download this paper

Title: A Synthesis of Technical Analysis and Fractal Geometry – Evidence from the Dow Jones Industrial Average 

Overview: The profitability of technical analysis has been investigated extensively, with inconsistent results. This paper seeks to develop new insights into the profitability of technical trading rules through a synthesis of fractal geometry and technical analysis. The Hurst exponent (H) emerged from fractal geometry as a means to detect long-term dependencies in a time series; the same dependencies that technical analysis should be able to identify and exploit to earn profits. Two tests of the synthesis are conducted using the thirty Dow Jones Industrial Average components. Firstly, the financial series are classified into three groups based on their H to determine if a higher (lower) H results in higher returns to trending (contrarian) trading rules. Secondly, the relationship between H and profits to technical analysis are estimated through OLS regression. Both tests suggest that the fractal nature of a time series explains a significant portion of the profits generated by technical analysis.

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Title:  Buy Low Sell High

Overview: Motivated by range-related trading practices, this paper investigates the return-predictive role of relative price level. As the price of a stock moves to an unusually high or low level with respect to a long-term trading range, concern about mean-reversion in the price becomes important. I test this hypothesis using a mean-reversion-based measure to proxy for the relative price level. Tests show that the measure is a significant and robust predictor of cross-sectional variation in stock returns. The results suggest that in the presence of uncertainty about duration of firm-specific shocks, deviation from a perceived range makes investors conservative, which creates abnormal performance of a “buy high and sell low” portfolio strategy. The relative price level effect is not driven by small-cap stocks and it is not a manifestation of momentum, reversal, the 52-week high, and volatility effects.

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Title:  A Classification Study of Carbon Assets into Commodities

Overview: This paper explores the classification of carbon assets generally considered as commodities by examining the characteristics of carbon prices. We propose a carbon price model reflecting the characteristics of the prices. The empirical studies using EUA (EU allowance) futures prices traded on the European Climate Exchange show that convenience yield of EUAs violates the property of commodities in terms of negative correlations between convenience yields of EUAs and EUA prices. It corresponds to the characteristics of the model we propose. Next, we examine mean reversion and seasonality of EUA futures prices often observed in commodity markets using AR(1) model with an annual sinusoidal trend. We show that EUA price analyses reject the existence of mean reversion and seasonality. We also examine the conditional correlations between EUA different delivery futures prices, resulting in almost positive correlations which may hold the same shape of the term structure as contango. In addition, the empirical studies using EUA option prices traded on the ECX show that carbon prices behave unlike commodities but like securities in terms of volatility smile. These empirical studies may support the counter argument to the classification of carbon assets into commodities.

>>> Download this paper

Title:  Baltic Dry Index as a Predictor of Global Stock Returns, Commodity Returns, and Global Economic Activity

Overview: The goal of this paper is to show that the growth rate of the Baltic Dry Index (BDI) has predictive ability for a range of stock markets, which is demonstrated through in-sample tests and out-of-sample statistics. The documented stock return predictability is also of economic significance, as seen by examining the certainty equivalent returns and Sharpe ratios of portfolio strategies that exploit the BDI growth rate. In addition, the BDI growth rate predicts the returns of commodity indexes, and we find some evidence for joint predictability of stock and commodity returns in a system of predictive regressions. Finally, the BDI growth rate predicts the growth in global economic activity, establishing further BDI’s role in revealing a link between the real and financial sectors.

>>> Download this paper