Saturday, April 29, 2017

Quantitative Trading: VIX Factor Model and Trend Following

More and more investors are using the power of computing technologies and quantitative techniques to manage their portfolios these days. They believe that quantitative trading can help reduce the PnL volatility resulted from emotional decision making and thus increase the consistency of returns. However, sometimes the machine beats the man, and sometimes it does not. Recently, quantitative funds seemed to suffer considerable losses after British Prime Minister Theresa May shocked markets by calling a snap election.

Among the most high-profile losers was Connecticut-based investment firm AQR Capital Management’s $13.3 billion computer-driven Managed Futures Strategy, which lost 1.1 percent on Tuesday, according to an investor who was told by the hedge fund, representing a loss of more than $130 million. The same strategy made 5.2 percent on the day the results of Britain’s EU referendum were revealed in June.
Two other hedge funds run by machines, which the investor declined to name, lost 2.8 percent and 1.9 percent. Read more

As pointed out by Maiya Keidan et al, the strategies that lost money were mostly trend-following in nature.

Trend following is a very popular strategy. Another, lesser-known type of quantitative trading, which we write extensively about in our blog, takes place in the volatility space. Specifically, volatility traders and hedgers bet on the future volatility dynamics or distribution of returns.  They can do so by using mathematical models to predict the implied and/or realized volatilities. One of the most popular volatility prediction methods is the  GARCH model. However, there exist other lesser-known quantitative methods, such as factor model that can be used to predict the volatility and help with decision making. As reported by Andrea Wong, such a factor model is being used by a hedge fund.

VIX as of Apr 28, 2017. Source: Yahoo finance
There are a number of reasons to heed the signals from Noorani and his team: their model, which analyzes around 30 macroeconomic factors from rate differentials to China’s credit default swaps, explains 91 percent of the movement in dollar-yen over a rolling four-month period. It sent out warning signals in mid-February before the dollar peaked. The framework was developed by Michael Hobson, a professor of astrophysics at the University of Cambridge. Read more

While quantitative trading is believed to be beneficial to many market participants, some observers and regulators are worried about its negative impact on the market, especially during a downturn. Recently Keith Savard wrote:

The risk of turmoil is even greater given that markets already are trying to absorb a technological revolution that includes enhanced algorithmic trading, the proliferation of electronic bond trading platforms and increased reliance on exchange-traded funds (ETFs).Read more

So is the jury still out whether we should embrace quantitative trading or not?

Article source here:  Quantitative Trading: VIX Factor Model and Trend Following

Friday, April 28, 2017

Hedging Interest Rate and Currency Risks

Yesterday we reported that a Japanese insurer decided not to hedge the currency risks in order to boost their returns

Hedging is too Expensive for This Insurer

Today Rupert Hargreaves wrote that in fact many Japanese insurers are following the same strategy

According to Bank of America’s findings, the investment plans remain largely unchanged from last year. Domestic yields are too low for buying Japanese Government Bonds, so life insurers are having to look overseas to acquire the yield they require.

“Insurers plan to increase their overall holdings of foreign bonds, much as they did in the previous term, but the weighting they give to each geographic region will greatly depend on the US rate hike environment, European political risk, and FX trends.”

However, the big change this time around is that these companies are planning to buy foreign bonds ex-currency hedging, which may have major implications for US corporate bonds. Read more

Not hedging requires that you have an accurate view of the market directions. Even if you do, it’s still beneficial to hedge.  For example, with the expectation of rising interest rates, corporate treasurers and Chief Financial Officers started thinking about how to hedge the interest rate risks.  Recently, Ajoy Bose-Mallick et al presented a good article on fixed income hedging. They argued that hedging is beneficial to both sellers and buyers:

Hedging the interest rate can protect both the lender and the borrower as it brings certainty to the interest rate costs and hence the available cash flows from the investment. This certainty means the borrower has one thing less to worry about on their investment. Below we highlight the key issues that should be considered

The authors also provided some examples of hedging strategies:

Type of hedge: Interest Rate Swap, Cap, and Collar are the main hedging instruments. The choice of hedge instruments should be aligned to the underlying business, and prevailing market conditions. An Interest Rate Swap fixes the interest costs and has the advantage of known costs, however it is not flexible if the loan is to be repaid prematurely. Fixing the interest rate also has the disadvantage of high opportunity cost in the case where interest rates remain low or become even lower. The Cap is an insurance-like instrument and protects the borrowers from interest rates going above a chosen level and lets borrowers take advantage of prevailing lower rates in case rates do not increase. The Cap can also be unwound at no further costs in case the borrower decides to pay the loan prematurely. However, a premium is required to be paid for a Cap hedge. The Collar hedge is a hybrid between an Interest Rate Swap and a Cap hedge and fixes the interest rate costs between chosen boundaries for zero or small up-front cost. No complicated or exotic hedges, such as callable hedges, should be considered and hedging notionals or tenors should not exceed the underlying loan notionals or tenor. Read more

Another, simpler, hedging technique that uses Forward Rate Agreement is presented by Sunil K Parameswaran:

Uncertainty regarding future rates of interest is a matter of concern to both potential borrowers as well as lenders. The former would be worried about the spectre of rising rates, while the latter would be concerned with the possibility of a rate decline. Consequently, both kinds of traders may wish to hedge the risk regarding future rates of interest. One such hedging tool is a forward rate agreement (FRA).

By using such a derivative one can lock in a rate of interest for a transaction scheduled for a future date. Forward rate agreements are cash settled. That is, on a specified future date the profit for one party, or equivalently, the loss for the other party would be computed. Read more

No matter what hedging strategy, simple or complex, we are using, we should have a good understanding of the hedging instruments, market environments, various regulatory and operational requirements.

Thursday, April 27, 2017

Hedging is too Expensive for This Insurer

Early this week, we provided further examples as why economic hedging is important for corporations

More Examples as Why Hedging is Important

One of the examples was Mitsui Life, a Japanese insurer who bought foreign bonds and then proceeded to hedge the currency risks. However, as  Tomo Uetake reported yesterday, another Japanese insurer thinks that FX hedging is too expensive and decided not to hedge:

Japan’s biggest private life insurer Nippon Life Insurance Co [NPNLI.UL] plans to boost foreign bond holdings without currency hedging in an effort to counter low domestic interest rates, senior company officials said on Wednesday.

Japanese insurers have been shifting into foreign assets in search of higher yields, but the biggest challenge has been how to secure sufficient returns after hedging against currency swings.
“When appropriate, we plan to buy foreign bonds without currency hedging this fiscal year (to March 2018), as we expect the dollar to strengthen gradually,” Naoki Akiyama, general manager for Nipon Life’s investment planning, told reporters. Read more

On the other hand, as pointed out by  Adriana Barrera et al., Mexican state-owned oil company Pemex still thinks that hedging to ensure price stability is important:

Mexican state-owned oil company Pemex will consider repeating a recently instituted hedging program in future years, as it looks to firm up its balance sheet and avoid the need for surprise budget cuts, a top executive said late on Tuesday.

Petroleos Mexicanos [PEMX.UL], as the company is officially known, reported on Tuesday that it has hedged its output through December, the first time it has done so in 11 years, as an insurance policy against volatile oil prices.

The oil hedging program, which will run from May to December and guarantees a price of $42 per barrel for up to 409,000 barrels per day, will cost the company $133.5 million. Read more

So what do you think?

Wednesday, April 26, 2017

Divergences in Equity and Fixed-Income Markets

As we discussed recently, divergences and anomalies can happen in financial markets, and this is exactly what is happening right now

Divergence Between Credit Default Swap and Equity Volatility

Yesterday, Tom Lee pointed out some diverging signs in the stock market:

First, Lee is concerned that the long-term yield curve has narrowed substantially. A flattening yield curve is a widely viewed marker of slowing economic growth, as this suggests the expected return of long-term spending then has smaller expected return on investment. The spread between the 30-year Treasury yields and the 10-year Treasury yields, as Lee observed, has flattened since just after the U.S. election in November “and historically signals market weakness ahead.”

“In the past, the bond market has been much better at ferreting out problems and smelling slowdowns; that’s the message from the yield curve. So I think the bond market is really taking the position that growth is going to disappoint, and the gap between the hard data and the soft data is still pretty big,” Lee said Monday. 

10 year Treasury June future. Source: Interactivebrokers

Next, he outlined that the credit spreads of high-yield debts started widening

Specifically, Lee notes that since 1998, the market has seen 30 instances in which high-yield spreads widened 60 basis points, as it did in late March, and the market saw a decline in 93 percent of instances (falling by a median 4 percent). The thinking is that high-yield indicates a tightening of financial conditions. Read more

As we discussed earlier, under normal market condition, a low-volatility equity market should be accompanied by low credit spreads.

On the same topic, Sid Verma reported on Bloomberg that there are disparities between the stock and bond markets.

In the green corner are stocks. The Standard & Poor’s 500 index is just 0.2 percent away from a record high reached in March on bets that Donald Trump’s administration will push through tax-code changes to spark growth. In the red corner sit U.S. government bonds, where benchmark 10-year Treasury yields have unwound almost half of their post-election increase, suggesting a far more pessimistic view the economy.

“The increasing divergence between global equity market performance and bond markets has raised questions as to whom is right,” Jefferies Group LLC analysts led by Sean Darby wrote in a note. Read more

How long will these divergences last and what would be the final outcome?
This is the question that everybody wants an answer.

Tuesday, April 25, 2017

Another Sign of Trouble for the Auto Industry

We recently reported that problems started emerging in the car loan sector:

Will Subprime Car Loan be the Next Big Short?
Credit Markets are Signaling Trouble

This week, Rebecca Ungarino of CNBC pointed out that the problem is not only in the loan defaults, but also in the decline of used-car prices:

Used-car prices are sliding, and some warn that this trend could have sharply negative effects on both relevant stocks and on the economy as a whole.
“This is a credit bubble in autos that is very reminiscent of the subprime mortgage crisis,” Larry McDonald, head of global macro strategy at ACG Analytics, said Friday in an interview on CNBC’s

And the decline in the used-car prices is already reflected in the credit default swaps of auto rental companies

Avis stock price. Source:

Bets on the failure of Hertz and Avis to repay their bonds, as measured by five-year credit default swaps, are on the rise as used-car prices fall and auto loan delinquencies edge higher. Elsewhere in the industry, automakers General Motors and Fiat Chrysler this month reported March sales figures that missed expectations; Read more

However, some experts argued that the market capitalization of the auto industry is too small to have a significant impact on the economy. We will see what happens next. In the meantime, and as always, risk management is key.

Monday, April 24, 2017

More Examples as Why Hedging is Important

Two weeks ago, in a post entitled To Hedge or Not to Hedge, we argued that it’s always important for corporations to hedge the commodity prices and not to speculate. This post continues with more examples that highlight the importance of economic hedging.

As oil price fluctuates, airlines can see their revenue vary widely. They can reduce the revenue volatility by hedging the fuel costs

Globally, risk managers quote Southwest Airlines’ long running (25 years) and successful corporate hedging programme, which makes up one-third of their costs. Ryan Air remains one of the latest examples of having hedged their exposures to the extent of 95% in 2017, having declared price certainty as their target than low prices. Singapore Airlines Ltd, remains another south-east Asian airline that has currently reported to have extended its hedging horizon from the previous 2-5 years hedging an average of 37% of its total fuel cost. Meanwhile, Malaysian Airlines has taken a prudent approach in the current oil price environment and has aggressively hedged 65% of their fuel oil requirements for 2017 at about a bit north of $60/bbl. While hedging is catching up as a healthy practice to protect the bottom lines among airline firms globally it is yet to catch up in World’s ninth largest civil aviation market—India, where the cost of fuel for an airline fluctuates widely from 28% to 63% of its total operating expense. Read more

Recently, the French election has caused some uncertainties in the market as it was reflected in the term structure of volatility.  As reported by Laura Dew, some portfolio managers did not leave it to chance and hedged their portfolios:

The latest hedge against potential turmoil in Europe employed by TwentyFour is via an option position on a weaker euro versus the US dollar.
With the euro/dollar back up close to $1.08, rather than $1.05 where it has recently been, even a more market friendly French election outcome may not cost money if the US dollar finds some of its prior inertia.
There is no such thing as a free option, but we think this is a cheap way of protecting some downside exposure to an event that may not be as clear cut as the polls suggest. Read more

As the results of increasing political risks in Europe, the corporate credit spreads started widening. Japanese investors took this opportunity to buy European bonds as an alternative to low-yielding domestic bonds. However, they have to hedge the currency risks, as pointed out by Hideyuki Sano:

Because they do not like exposure to foreign exchange fluctuations, they use currency hedging on a large part of their foreign bond investment.
The hedging costs are closely tied to short-term interest rate gaps between currencies and rises in dollar interest rates mean hedging will become costlier for Japanese investors.
On the other hand, because the euro zone’s short-term interest rates are deep into negative territory, hedging for the euro costs almost nothing, or sometimes even produces extra returns. Read more

The above examples provided insights into large corporation hedging programs and clearly demonstrated the importance of hedging.

Article source here:  More Examples as Why Hedging is Important

Saturday, April 22, 2017

Credit Markets are Signaling Trouble

A few weeks ago, we reported that problems started emerging in the car loan sector

Will Subprime Car Loan be the Next Big Short?

This week, Rupert Hargreaves of Valuewalk pointed out that the defaults in the auto sector started to spread out to other areas of the market:

“Will rising consumer default rates spread from autos to other loans? Yes. We are already seeing evidence that subprime personal unsecured and credit card delinquency rates are rising from low levels in recent vintages, and bank loan officer surveys validate this thesis. Further, poor performance in auto loans is increasingly emerging not only in subprime but also non-prime (and some prime) loans.” Read more

Likewise, on the corporate credit market side, Bob Stokes recently wrote that European credit spreads are widening, meaning that investors have become more fearful:

Many European bond investors are not so confident about the future.
Yield spreads between investment grade bonds and lower quality debt has been widening. This means investors in the shakier debt perceive a greater risk of defaults, so they’re demanding a higher yield for assuming that risk.

The bond market is behaving much as it did before previous credit crises in 2008, 2010 and 2012. … On February 7, French 10-year notes sank to an 18-month low, sending French spreads over German debt (top chart) to their widest level since early 2014. Dutch and Italian spreads (middle and lower chart) have likewise widened, recently touching respective three-year highs. Read more

However, despite these warning signs, the equity volatility still remains relatively low.  In fact, Nicholas Spiro wrote

The ability of markets to climb a “wall of worry” and turn a blind eye to the plethora of vulnerabilities facing the global economy – from the rapid build-up of corporate debt in China to the dangers in exiting ultra-loose monetary policies, particularly in Europe and Japan – seems to know no bounds. This makes it nigh impossible for economists and investment strategists to predict with any degree of certainty the catalysts and precise timing of the next major financial crisis

He also pointed out a reason for the subdued volatility

International investors – initially speculative ones such as hedge funds, but more recently long-term institutional investors – have been placing big bets on volatility remaining subdued for the foreseeable future. These bets, known as “shorting”, or selling, volatility in Wall Street parlance, have proven extremely profitable and are suppressing volatility further.

Yet the more subdued the volatility, the greater the distortion in asset prices and, once financial turmoil finally erupts, the bigger the scope for a much more disorderly sell-off than would otherwise be the case if investors had not been selling volatility over the past several years.

What is clear is that the Vix has become a poor gauge of investors’ sensitivity to the vulnerabilities and threats in the global economy that could precipitate the next crisis. Read more

So which market is right, equity or credit?

Thursday, April 20, 2017

Selling Naked Put Options is Risky

As of the close of today, the VIX index seems to be going down again. With a decreasing VIX, investors might start thinking about selling volatility. In fact, a post by Ellen Chang today discussed selling naked puts. The post started with favoring put selling, but it then pointed out some risks involved in shorting volatility:

While there is a limited upside, sellers of options should be cautioned that there is a greater downside loss because you could lose than more than 100% of your original capital invested.
Writing options to generate higher returns comes with a large amount of risk and “collecting an immediate payoff is not as easy as it sounds
Options writers are often compared to the house of a casino,” Ma said. “It only makes sense if you have the large cashflow to pay out in the short run. Remember, in the long run, the house always wins.
Shorting the indexes is one strategy to profit from increased volatility, but most investors are not comfortable doing because of the increase in risk, said Meredith Zidek, a Hunt Valley, Md.-based options and ETF trader.
Read more

The chart below shows the VIX index from 2010 to the present.

As we can observe from the chart, the VIX has exhibited several sharp spikes following relatively quiet periods. This means that selling naked puts and not managing them correctly is indeed a risky business.

On the research side, a recent paper entitled Forecasting a Volatility Tsunami by A. Thrasher presented several studies on the volatility spikes. It also provides a method for predicting those spikes. Although we still haven’t had any opinion yet on the merits of this prediction method, we think the paper is worth a read

The empirical aim of this paper is motivated by the anecdotal belief among the professional and non-professional investment community, that a “low” reading in the CBOE Volatility Index (VIX) or large decline alone are ample reasons to believe that volatility will spike in the near future. While the Volatility Index can be a useful tool for investors and traders, it is often misinterpreted and poorly used. This paper will demonstrate that the dispersion of the Volatility Index acts as a better predictor of its future VIX spikes.

Monday, April 17, 2017

Divergence Between Credit Default Swap and Equity Volatility

In a previous post, we examined the relationship between the Credit Default Swap (CDS) and equity volatility, and argued that there is a strong correlation between them.  But like any relationship in financial markets, this one can break down and divergence can happen.

For instance, last month we noticed that CDS in Asia and Australia tightened considerably with respect to their US counterparts. Bloomberg actually reported:

Credit-default swaps on the bonds of every Asian emerging market except for South Korea have tumbled this year, outperforming debt risk for the U.K. and for France, which has jumped amid the presidential election campaign. Inflows into developing Asian bond markets have also swelled in 2017 as investors bet the world’s fastest-growing region will be able to better withstand the volatility and outflows unleashed by a tightening Federal Reserve.

“Emerging Asia scores relatively well on both macro as well as political stability and is likely to remain an attractive region to invest in for the foreseeable future,” said Anders Faergemann, a senior fund manager in London at PineBridge, which manages about $83 billion globally. “The short-term risk is mainly associated with external factors as the markets fear the Fed is behind the curve.” Read more

This tightening of CDS in Asia presented an interesting trade opportunity.  Indeed, Asia Unhedged pointed out:

The difference between emerging market (EM) and US corporate BBB Option-Adjusted Spread is at an all-time low. The difference between EM volatility and VIX is around the average. This chart begs the question: Is there a trade in shorting credit and buying equity? Read more

This means that the EM CDS is relatively low with respect to the US counterpart when taking the volatility differential into account.  The post also suggested going long EM equity and short its CDS.

So this is an example of divergence. But it’s important to note that it happens between the VIX and CDS  differentials, i.e. it represents a dislocation between secondary risks, and not primary risks.

 Article Source Here: Divergence Between Credit Default Swap and Equity Volatility

Saturday, April 15, 2017

Pricing Convertible Bonds and Preferred Shares

A convertible bond (or preferred share) is a hybrid security, part debt and part equity. Its valuation is derived from both the level of interest rates and the price of the underlying equity. Several modeling approaches are available to value these complex hybrid securities such as Binomial Tree, Partial Differential Equation and Monte Carlo simulation. One of the earliest approaches was the Binomial Tree model originally developed by Goldman Sachs [1,2] and this model allows for an efficient implementation with high accuracy. The Binomial Tree model is flexible enough to support the implementation of bespoke exotic features such as redemption and conversion by the issuer, lockout periods, conversion and retraction by the share owner etc.

In this post, we will summarize the key steps in valuing a convertible bond using the Binomial Tree approach. Detailed description of the method and examples are provided in references [1,2].

Generally, the value of a convertible bond with embedded features depends on:
  • The underlying common stock price
  • Volatility of the common stock
  • Dividend yield on the common stock
  • The risk free interest rate
  • The credit worthiness of the preferred share issuer
Within the binomial tree framework, the common stock price at each node is described as

where S0 is the stock price at the valuation date; u and d are the up and down jump magnitudes. The superscript j refers to the time step and i to the jump. The up and down moves are calculated as


where is the stock volatility, and  is the time step.

The risk neutral probability of the up move, u, is

and the probability the down move is 1-p

After building a binomial tree for the common stock price, the convertible bond price is then determined by starting at the end of the stock price tree where the payoff is known with certainty and going backward until the time zero (valuation date). At each node, Pj,i  the value of the convertible is

where m denotes the conversion ratio.

If the bond is callable, the payoff at each node is

The payoff of a putable bond is

Here C and P are the call and put values respectively; r denotes the risk-free rate.

The above equations are the key algorithms in the binomial tree approach. However, there are several considerations that should be addressed due to the complexities of the derivative features
  • Credit spreads (credit risk) of the issuers which usually are not constant.
  • Interest rates can be stochastic.
  • Discount rate ri,j depends on the conversion probability at each node. This is due to the fact that when the common share price is well below the strike, the preferred share behaves like a corporate bond and hence we need to discount with a risky curve. If the share is well above the strike then the preferred behaves like a common stock and the riskless curve need to be used.
  • The notice period: the issuer tends to call the bond if the stock price is far enough above the conversion price such that a move below it is unlikely during the notice period. For most accurate results, the valuation would require a call adjustment factor. This factor is empirical and its value could be determined by calibration to stock historical data.
This pricing approach can be implemented in scripting languages such as VBA and Matlab. In the next installment, we will provide a concrete example of pricing a convertible bond. If you have a convertible bond that you want us to use as example, send it to us.

[1] Valuing Convertible Bonds as Derivatives, Quantitative Strategies Research Notes, Goldman Sachs, November 1994.
[2] Pricing Convertible Bonds, Kevin B. Connolly, Wiley, 1998.

 The post Pricing Convertible Bonds and Preferred Shares first appeared on Relative Value Arbitrage

Friday, April 14, 2017

Is Volatility Back for Good?

The week ended with high implied volatilities across the board. Eric Lam et al. at Bloomberg wrote:

The calm in stocks worldwide is giving way to concern, with investors in Europe and the U.S. rushing to hedge against declines and a Credit Suisse Group AG index flashing a warning as the list of economic and political obstacles grows.

There’s no shortage of potential concerns. Tensions over North Korea’s nuclear program have intensified days after the U.S. fired missiles at a Syrian airfield. There’s uncertainty over the outcome of the French election, with the first round scheduled for April 23, and in Britain doubts are emerging on whether the economy can withstand the political shocks the Brexit negotiations will bring. Read more

So it seems that investors are very concerned with the uncertainties these days.

Interestingly, just about 10 days ago, Joe Mallen et al. of Helios Quantitative Research presented an interesting chart that showed a divergence between the index of economic policy uncertainty and the VIX. The authors then concluded that most investors have become desensitized to the news headlines:

It seems most investors over the years have simply become desensitized to the volume of squawking news headlines.  In more recent days, despite economic policy stories that usually cause market trepidation – such as healthcare reform (or lack thereof), the debt ceiling debate, and short term interest rate hikes to name a few – the US equity market has trended to very low levels of volatility. So, why do some investors say this environment feels so volatile, but traditional measures of volatility remain historically low?  Read more

So currently are investors oversensitive?
After the French election, will we be back to the low volatility environment again?

Is It a Good Time to Go Long Volatility?

Last week, in the post entitled

This ETF Helps Investors Hedge Market Risks

we discussed how it’s important to hedge against a market downturn, and pointed out some strategies for doing it.

Yesterday, Brian Chappatta reported that some big portfolio managers already started buying volatility

Some of the world’s biggest bond managers have been waiting for this moment. Rather than ponder the sustainability of the reflation trade and its implication for yields, investors including Rick Rieder at BlackRock Inc. and Bob Michele at J.P. Morgan Asset Management say they’ve been betting that price swings will grow more dramatic in the days and months ahead. That’s already borne fruit this week, with the CBOE/CBOT index of 10-year Treasury note volatility, known by its ticker TYVIX, jumping to the highest closing level since February. Read more

On the research side,  Chrilly Donninger timely published a paper on how to protect a portfolio from a tail risk event:

Protecting an equity market portfolio with VIX-Futures eats not only the kurtosis but also the profits of the portfolio. Being constantly VIX-Futures long is too expensive Therefore one has to find an  appropriate timing strategy.  This working paper presents a Hidden-Markov-Model which not only has  a reasonable tail-risk-protection but even improves the overall return of the SPY. The strategy is – at  least in the historic simulation – close to what is called in German an “eierlegende Wollmilchsau” (“egg-laying wool-milk-sow”). Read more

Thursday, April 13, 2017

Are You Betting on Terminal Distribution or Volatility Dynamics?

In volatility space, many investors don’t know exactly what they’re betting on. Briefly, with options, they can bet on:
  1. Terminal distribution of returns
  2. Dynamics of the volatility
Today, we noticed an article by Alex on Valuewalk that discussed these 2 types of options trade. It concluded:

The key takeaway here is:
Traders who don’t hedge delta rely on the trend of the underlying more than its volatility to profit.
Traders who do hedge delta rely on the volatility of the underlying more than its trend.

It usually doesn’t make sense to hedge your delta unless you have a professional commission structure. This is why so few do it. All those hedging trades rack up commissions. And the execution of those hedges requires a lot of screen time or advanced software than can do it automatically.

So if you’re not delta hedging, a better question to ask yourself before placing an option trade is:
Do I believe the underlying will trend or consolidate over the life of the option?

If your answer to that question is “I think the underlying will trend”, you should buy optionality. The underlying will trend away from the strike price and you’ll make money on the option you purchased.

If your answer to that question is “I think the underlying will consolidate”, you should sell optionality. The underlying will stay close to the strike price and you’ll collect the premium from the option you sold.
Read more

We agree with some points in the article. However, we note that:

-Even if an investor does not rehedge, i.e. he’s betting on the terminal distribution, the volatility when he enters the trade does matter. It’s the price that he pays for his option and it determines his final payout.
-The article did not discuss the long term expectancy of these types of bet which is important to know when putting on a new trade.

Wednesday, April 12, 2017

Market Correlations Started to Break Down

Last week, we noticed that the volatility term structure was inverted on a low reading. In fact, Crystal Kim wrote:

Under normal circumstances, VIX futures curve upward. It's entirely logical -- the longer dated futures trade at a premium to shorter-dated futures. An inversion, as seen yesterday, suggests that the market expects more volatility in the short-term than the long-term.
The reason behind the volatility bid: upcoming elections in France. "The April VIX futures are bid ahead of the French elections, since they will settle into a 30-day VIX that captures both rounds of voting," he says. "The U.S. options market is finally starting to care about the French elections." The first round is set for April 23. If no one wins the majority, a run-off between the top two will take place on May 7. Read more

Vix futures term structure as of Apr 12, 2017. Source:

But these days  anomalies are happening not just in the volatility space.  As pointed out by Kathleen Brookyesterday, the CDS market is also acting out of sync.

On the one hand there is a smell of caution in the air, but on the other, capital is not yet moving away from risky assets.
The US corporate high yield spread should be used to time market moves rather than risk sentiment indicators. The US corporate high yield spread has a significant negative weekly correlation with the S&P 500 at -60% for the last two years. If this correlation is to hold, then we would expect the S&P 500 to continue to rally if the US corporate high yield spread continues to narrow, and vice versa. Read more

And finally today observed a breakdown in correlations

At the start of 2017 the correlation between the S&P 500 and the high yield corporate spread was -53%. This seems normal as you would expect these products to move inversely to each other: as the S&P 500 rises, high yield debt falls and vice versa. However at the start of April this correlation had reversed to 33%, so now the S&P 500 and the high yield debt spread move together a third of the time. This suggests that 33% of the time when the S&P 500 falls, so too does the price of credit for high risk US corporations. Usually you would expect the opposite to occur. Read more

Last and not least, these articles also gave a warning of an imminent market correction.

Tuesday, April 11, 2017

Another Look at Prepayment Risk of Mortgage-Backed Securities

Yesterday the Federal Reserve Chair Janet Yellen said at a University of Michigan event that the Fed planned to raise short-term interest rates.

“I think we have a healthy economy now … but it’s been a long time coming,” Yellen said.
Yellen said the current unemployment rate of 4.5% is “even a little bit below” what Yellen and her other colleagues at the Fed would consider “full employment.” She said inflation is “reasonably close” to the Fed’s stated goal of two percent. Read more

In a previous post, we argued that rate hikes will increase volatility through hedging of prepayment options embedded in mortgage-backed securities.

Recently, Mark Robinson presented another argument:

Analysis from SocGen published during the fourth quarter of 2016 points to a 2.6 per cent return on 10-year notes (the equivalent rate for the UK was 1.7 per cent). This reflects the general view that US equity valuations are stretched based on underlying earnings. If we accept that once investments in riskier assets such as equities are deemed relatively expensive to government-backed debt, then stocks could be subject to bigger price swings with increased frequency. Read more

This means  that when interest rate rises, equities  will appear to be expensive relative to government-backed bonds, hence they will be susceptible to selling, thus causing an increase in volatility.

Regardless of the argument, with a rising rate, one might think that it’s risky to invest in fixed-income securities.  However, Tim Mullaney  recently reported that:

Gundlach, CEO of DoubleLine Capital, is betting that the best way to play the coming rate hikes is by holding lots of mortgages

But how about prepayment risk?

“Gundlach doesn’t see prepayment risk as particularly high right now, but if prepayments spike, there’s a risk of losses for the fund.” Read more

Good investment decision sometimes seems counterintuitive.  And if this is true, then prepayment risk will not be a threat to market volatility. Let’s see how this plays out.

Originally Published Here: Another Look at Prepayment Risk of Mortgage-Backed Securities

Where Has the Volatility Gone-Part Trois

Yesterday we published a note regarding the debate about ETFs and their impact on the current low volatility environment

To add to the “against camp”, Zerohedge just published a post, citing Eric Peters, the CIO of One River Asset Management:

“The people who are indexing now are the same ones who were selling in 2009,” continued VICE, agitated. “I just spoke at a conference filled for wealth advisors from all the major players. They say the same thing - today’s buyers are not long-term investors.” They’re guys who put $1mm into index ETFs.
“When they lose 6%-7% and decide to sell, who will be on the other side of those trades?” And the stocks that will be savaged worst will be the ones that lagged the indexes on the way up. “It reminds me of 2000, when people piled into the QQQs.”
“I don’t know when the next major crisis will hit, no one does,” admitted VICE. “But I do know that even in the next normal correction, the market’s losses will be amplified enormously by this move away from active management.”

This means that ETF actually increases the market volatility, especially during a downturn.

Monday, April 10, 2017

Where Has the Volatility Gone-Part Deux

Last week, we asked a question “Do ETFs really cause the low volatility” in this post

Where Has the Volatility Gone?

Today, CNBC released another article on the same topic. This time, the article features opposing points of view from notable researchers. Some experts agree that the rise of ETFs has caused the volatility to decline

“There’s no one resounding answer to [why we’ve seen] this low volatility,” Repetto, who covers the brokers and exchanges, said Tuesday on CNBC”s “Trading Nation.” But the growth of assets in exchange-traded funds, which largely track indexes, “has had some impact.”
Repetto pointed out that the first quarter of 2017 was the least volatile quarter for the S&P 500 in decades — which is just one among a host of stats showing how anomalous the lack of market movement has been.

While some disagree:

“To a large extent, I disagree that low volatility is being caused by ETFs,” Meziani, the author of three books about exchange-traded funds, told CNBC in a Thursday phone interview.
Read more

Volatility Trading Strategies, a Comparison of Volatility Risk Premium and Roll Yield Strategies

Volatility trading strategies

In previous posts, we presented 2 volatility trading strategies: one strategy is based on the volatility risk premium (VRP) and the other on the volatility term structure, or roll yield (RY).  In this post we present a detailed comparison of these 2 strategies and analyze their recent performance.

The first strategy (VRP) is based on the volatility risk premium.  The trading rules are as follows [1]:

Buy (or Cover) VXX  if VIX index <= 5D average of 10D HV of SP500
Sell (or Short) VXX  if VIX index > 5D average of 10D HV of SP500

The second strategy (RY) is based on the contango/backwardation state of the volatility term structure. The trading rules are as follows:

Buy (or Cover) VXX if 5-Day Moving Average of VIX/VXV >=1 (i.e. backwardation)
Sell (or Short) VXX if 5-Day Moving Average of  VIX/VXV  < 1 (i.e. contango)

Table below presents the backtested results from January 2009 to December 2016. The starting capital is $10000 and is fully invested in each trade (different position sizing scheme will yield different ending values for the portfolios. But the percentage return of each trade remains the same)

Initial capital 10000 10000
Ending capital 179297.46 323309.02
Net Profit 169297.46 313309.02
Net Profit % 1692.97% 3133.09%
Exposure % 99.47% 99.19%
Net Risk Adjusted Return % 1702.07% 3158.54%
Annual Return % 44.22% 55.43%
Risk Adjusted Return % 44.46% 55.88%
Max. system % drawdown -50.07% -79.47%
Number of trades trades 32 55
Winners 15 (46.88 %) 38 (69.09 %)  

We observe that RY produced less trades, has a lower annualized return, but less drawdown than VRP. The graph below depicts the portfolio equities for the 2 strategies.
volatility risk premium and roll yield strategies
Portfolio equity for the VRP and RY strategies

It is seen from the graph that VRP suffered a big loss during the selloff of Aug 2015, while RY performed much better. In the next section we will investigate the reasons behind the drawdown.


Performance during August 2015

The graph below depicts the 10-day HV of SP500 (blue solid line), its 5-day moving average (blue dashed line), the VIX index (red solid line) and its 5-day moving average (red dashed line) during July and August 2015. As we can see, an entry signal to go short was generated on July 21 (red arrow). The trade stayed short until an exit signal was triggered on Aug 31 (blue arrow).  The system exited the trade with a large loss.
volatility risk premium relative value arbitrage
10-day Historical Volatility and VIX

The reason why the system stayed in the trade while SP500 was going down is that during that period, the VIX was always higher than 5D MA of 10D HV.  This means that 10D HV was not a good approximate for the actual volatility during this highly volatile period. Recall that the expectation value of the future realized volatility is not observable. This drawdown provides a clear example that estimating actual volatility is not a trivial task.

By contrast, the RY strategy was more responsive to the change in market condition. It went long during the Aug selloff (blue arrow in the graph below) and exited the trade with a gain. The responsiveness is due to the fact that both VIX and VXV used to generate trading signals are observable. The graph below shows VIX/VXV ratio (black line) and its 5D moving average (red line).
volatility term structure relative value arbitrage
VIX/VXV ratio

In summary, we prefer the RY strategy because of its responsiveness and lower drawdown. Both variables used in this strategy are observable. The VRP, despite being based on a good ground, suffers from a drawback that one of its variables is not observable. To improve it, one should come up with a better estimate for the expectation value of the future realized volatility.  This task is, however, not trivial.

[1] T Cooper, Easy Volatility Investing, SSRN, 2013

Article source here:  Volatility Trading Strategies, a Comparison of Volatility Risk Premium and Roll Yield Strategies