Proxy battle

Tuesday, March 27, 2007

It’s been another fairly quiet day so far as markets digest yesterday’s impressive mid session rally in US equities. Although the Nikkei had a bit of a shocker overnight, submarining Macro Man’s JGB profits, European equities have traded on the front foot thus far. Hawkish comments from the ECB and a robust ifo report have sent European fixed income lower; sadly, Macro Man never added to his profitable Euribor trade. At this juncture, it is probably too late to add until the ECB suggests the possibility of 4.25%. The keynote event of the week, however, will be Bernanke’s Congressional testimony tomorrow.

A quiet day like this allows Macro Man to reflect on trading methodology. Regular reader wcw asked yesterday why Macro Man did not sell a synthetic RUF index as opposed to the XHB trade that he actually executed. Setting aside the prosaic rationale of not being familiar with the RUF (Macro Man typically tracks the HBS index to monitor

In this case, it appears that it does. XHB and the RUF index appear very highly correlated, as indicated by the chart below. While the RUF has fallen in (pardon the pun) somewhat more than XHB, this is simply a function of volatility: 40 day historical vol for RUF is 33, while it’s only 27 for the XHB. Given that the actual trade was constructed on a fairly volatility neutral basis (short $5 million XHB at 27.3 vol; long $10 million SPX at 14.5 vol), it appears to Macro Man that XHB was in fact an acceptable substitute for the underlying index, whether RUF or HBS.

However, Macro Man has come unstuck using less perfect proxies in the past. His recent experience with AUD/CHF and EUR/HUF ‘hedges’ on the long SPY beta position still sticks in the craw. Indeed, he is still suffering from a proxy battle: his long Goldcorp position has lagged bullion very badly indeed.

So allow Macro Man’s pain to be your gain. Next time you have a strong view on an asset and are tempted to trade a proxy as a Heinz position (ketchup- get it?!?), be wary. Today’s great proxy trade- like USD/ZAR and the SPX...

...could well be yesterday’s, and indeed tomorrow’s, lesson that correlation does not imply causality.Indeed, Macro Man would not suggest trying to proxy trade Series 1 below with Series 2. An ancillary quiz for those interested: anyone who can correctly identify the apparently correlated series in the chart below will win an actual prize (to be determined.)

Elsewhere, the 660 puts expire today, likely worthless. Macro Man sells out his futures hedge at 665.50, locking in a modest profit for the trade since inception.

Posted by Macro Man at 10:49 AM  


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