Saturday, 12 September 2015

Burger parity

16:18 Posted by The Thalesians (@thalesians) No comments

I recently visited Frankfurt and Zurich to help launch Thalesians quant finance talks there (a special thanks goes to Jochen Papenbrock, Adrian Zymolka and Swati Mittal for organising the events there). Travelling from Frankfurt to Zurich, I noticed several major differences.

One difference is the language. I can vaguely understand Hochdeutsch, as it is spoken in Frankfurt and the rest of Germany, owing to a few years studying German, during a period of my life when I could be called young (and importantly, my mind has not yet quite expunged all the German I learnt then). By contrast, my ears have some trouble understanding Schweizerdeutsch, the dialect of German spoken in Switzerland, simply because I am not used to it.

Another difference is the geography. Frankfurt to my untrained eye is relatively flat, making it pretty easy to get around on foot. In Zurich, the hilly terrain makes it somewhat more challenging to navigate to certain neighbourhood, such as the area around ETH, where I gave my Thalesians talk and where I had the opportunity to meet Nassim Taleb, through a combination of randomness and Twitter!

However, the difference I'd like to focus on is price. Perhaps, it is not an understatement, to note that Zurich and Switzerland in general feels expensive for visitors. One of the easiest ways to test this is to use the Big Mac index, maintained by the Economist, which gives you the relative cost of a Big Mac in a number of different countries. The idea is that you can work out how overvalued (or undervalued) a certain currency by assessing the price of similar goods in different countries. In practice, you would aim to choose a basket of goods, rather than a single item, like a Big Mac in such an index, which is referred to as a Purchasing Parity Power index,. As an aside, how much do this the burger costs at the top, which I had in Zurich (clue: it was rather more expensive than I would have liked...)? Using the Big Mac index, we note that in Switzerland, a Big Mac costs 6.82 USD. By contrast in the UK, it is 4.51 USD and in the Eurozone it is 4.05 USD.

We are now going to use this information to work on a little problem. Let's say, we had 5 USD and we wanted to share out Big Macs in Zurich, London and Frankfurt, as prizes. Whilst, in London and Frankfurt, we could give people a whole Big Mac and still have change. However, in Zurich, we would end up giving out less a full Big Mac. This would be kind of unfair, a prize in Zurich would be far less.

Yet, this is exactly what people can do when they invest, based on notional amounts of different assets. However, the "risk" that such an approach buys is unequal. A dollar worth of bonds is less risky than a dollar of equities. If you have a fund which runs a multi-asset strategy, trading all manner of different assets, if they scale purely by notional, rather than risk, the portfolio could have considerably different exposures to those intended.

There has been much in the press recently, talking about the recent performance of risk parity, which basically attempts to allocate in this fashion based on risk, rather than purely notional. Of course any strategy is not going to outperform all the time. What has been lost in the argument is why risk parity is used, namely that assets do not all have the same risk profiles. For example for trend following funds, if they had no method to adjust for the risk differences in their portfolios, they would end up being dominated by the highest volatility assets, like crude oil, whilst having little exposure to lower risk assets like bonds.

So yes, strategies might not always outperform all the time. But it is important to consider, what the alternatives are. In the meantime, parity is just as important for burgers as it is for risk...

If you're on the US East Coast, I'll be in Washington DC 27 Sep, NYC 29 Sep-3 Oct and Boston 5 Oct if you'd like to meet me and hear more about systematic trading! If you're in mainland Europe, I'll be in Paris 6-9 Oct at the WBS Fixed Income conference, where I'll be hosting a systematic trading workshop.

Like my writing? Have a look at my book Trading Thalesians - What the ancient world can teach us about trading today is on Palgrave Macmillan. You can order the book on Amazon. Drop me a message if you're interested in me writing something for you or creating a systematic trading strategy for you! Please also come to our regular finance talks in London, New York, Budapest, Prague, Frankfurt, Zurich & San Francisco - join our group for more details here (Thalesians calendar below)

21 Sep - New York - Agostino Capponi - Arbitrage-Free Pricing of XVA (Thalesians/IAQF)
23 Sep - London - Stephen Pulman - Multi-Dimensional Sentiment Analysis
01 Oct - New York - Saeed Amen - How to build a CTA? / interactive Python demo
05 Oct - Boston - Saeed Amen - Trading Thalesians Book Talk / PyThalesians Python Interactive Demo (Boston Algorithmic Trading Meetup Group)
09 Oct - Budapest - Taylor Spears - On the Sociology of CVA
14 Oct - New York - Dan Pirjol - Can one price Eurodollar futures in Black-Derman-Toy? (Thalesians/IAQF)
21 Oct - London - Robert Carver - Lessons from systematic trading


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