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How to assess macro developments – a case for Game Theory

How to assess macro developments – a case for Game Theory

By Brian Singer and Thomas Clarke
Friday 9th December 2016

It is no secret the last few months have posed significant challenges for investors with various events having a sizeable impact on markets. Of these, the UK’s decision to leave the EU is the most obvious, but numerous others have all impacted markets at a macro level in some way. There are now others on the horizon – the repercussions of the US presidential election alone may be substantial, even before others are considered.

How to assess macro developments – a case for Game Theory

For a long time, the focus for multi-asset managers has been solely on fundamental value and the pull this exerts on the price of markets and currencies over longer-term horizons. While this remains a useful tool, alone it is increasingly insufficient; a more detailed understanding is needed of macro developments and their ability to drive prices towards or away from fundamental value.

Of the methods available, Game Theory stands out as offering a particularly comprehensive means of assessing macro developments. The strategy is a set of principles allowing the sequential, strategic interactions of multiple actors to be scrutinised within particular scenarios. These actors could be the parties at the negotiating table in a Middle East conflict, those participating in discussions to resolve the US debt ceiling battle, or different players seeking to resolve the eurozone crisis.

Regardless of the scenario, the principles remain the same – each party will act in its best interests and will respond to other parties’ actions via cooperation or conflict. The outcomes will ultimately depend on individual actors’ objectives, their ability to exert influence, the resulting actions they may be able to take, and the degree of importance the actions and potential implications has to the participant.

How does this lead to an investment decision? There is a vast amount of information affecting global economies and markets, all of which needs to be processed so as to position portfolios so they profit accordingly. Game Theory allows risk capital allocators to clearly understand individual scenarios and, based on a logical assessment of the different parties involved, accurately predict outcomes, and revise portfolio exposures to profit from these events.

An example of Game Theory in practice is the pre-Brexit world of the eurozone during the Greek debt crisis. In this scenario, each eurozone country, as well as the ECB and IMF, had its own individual objectives, ranging from debt reduction, to maintaining the euro currency, to individual actors protecting their own prestige in the wake of populist sentiment.

How does Game Theory help? First, it provides a straightforward and structured framework to identify the various players involved in a particular scenario; their objectives; and how high a priority individual objectives are relative to others.

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Having identified the different players and their motivations, Game Theory also allows clear assessments to be made as to the strengths and weaknesses (or “dimensions of net influence”) each actor wields, the amount of control they are able to exert over other players, and the means by which they can do this.

We can also use this theory to identify commonalities of interest and the potential for certain parties to act in collaboration (“coalition power”), the amount of risk they are willing to accept, and the importance (or “salience”) of the issue to each individual player. To take the debt crisis as an example – we can clearly see Germany and Greece were prepared to take more risk than others, while Greece saw the debt issue as being far more important than any other player.

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While this may seem somewhat complicated, in reality Game Theory provides a clear and logical means of comprehensively assessing individual events and their likely outcomes, based on the motivations of the players involved and what each of these actors is ultimately prepared to do to meet their aims. To complete the eurozone example: risk capital allocators using Game Theory would have known to initially decrease exposure to European equities early in the 3rd quarter of 2015 after  Greece rejected a proposed bailout, but then to subsequently increase exposure to both broad European equities as the contours of a deal with Greece took shape.

It would then suggest further increasing European equities, both broadly as well as granularly—in Spain and Italy—as a populist swell was successfully quelled and undervalued markets were likely to see some near-term benefits from the relative calm expected to ensue.  Further, long UK equity exposure was moved to a non-linear profile such that downside protection was established and done so relatively cheaply on the back of below-average levels of implied volatility.  These navigational moves allowed for savvy investors to both profit from events and limit the potential for downside risk.

Game Theory does not just help to find opportunity; it can also help protect against downside risk as well. Ahead of the UK’s referendum on leaving the European Union, most polls suggested a victory for the Remain camp. However, by using the Game Theory framework, investors would have seen that the downside risk of a leave result far outweighed the upside potential of a vote to remain.

Assessment of fundamentals will always retain a significant role in investment decision making, and Game Theory provides a powerful tool that can accurately guide risk capital allocation decisions and successful portfolio positioning.

Brian Singer and Thomas Clarke (pictured) are co-portfolio managers, Dynamic Allocation Strategies at William Blair

 

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