This ETF Helps Investors Hedge Market Risks

In previous two posts we discussed the benefits of using tail-risk hedge funds to dampen portfolio volatility:

HedgeFunds Help Dampen Market Volatility

NowIs The Time to Hedge, But The Cost of Insurance Can Be Expensive

Recently Max Chen reported that Cambria Investments is rolling out a tail-risk protection ETF:

TAIL tries to provide income and capital appreciation from investments in the U.S. markets while protecting against downside risk, according to a prospectus sheet.

The active ETF will invest in cash and US. government bonds, and utilizing a put option strategy to manage the risk of a significant negative movement in the value of domestic equities, or more commonly known as tail risk, over rolling one-month periods.

While we don’t fully understand the last paragraph:

Additionally, since the put options generate premiums or income, TAIL investors may also have access to an alternative yield-generating asset. Many investors are stretching for yield and taking on risk in a low-interest-rate environment, and this tail risk strategy may provide a good alternative.

Read more

i.e. why the ETF buys out of the money put options, and these options can generate income at the same time, we agree that there is a need for funds that protect investors in a market downturn. To be able to add any value, such a fund should provide the protection in an economical way.

To Hedge or Not to Hedge

Last week, Bloomberg presented a fascinating story about Mexico’s secretive oil hedging program. We noted that while it was designed as a hedge,  the Mexican government has made money consistently with it.

If anything, recent results have made the Mexican government look especially good. The country earned $6.4 billion in 2015 and $2.7 billion in 2016 [and $5.1 billion in 2009]. Read more

Crude Oil May future. Source: barchart.com

On the opposite side, Florida utilities have lost money consistently with their hedging programs.  Susan Salisbury reported:

In the past 15 years, Florida’s four investor-owned utilities have lost close to $7 billion due to natural gas hedging programs. That’s because the utilities have purchased much of their gas through hedging contracts at locked-in prices rather than on the open market, and gas prices have declined for the most part. Read more

So the question is: to hedge or not to hedge?

We think that the Mexican government’s and Florida utilities’ hedging programs are 2 extreme cases. We always believe that it’s important for commodity producers to hedge the commodity prices and not to speculate. After all, hedging is another form of insurance.

In this regard, a post on bizcommunity.com pointed out:

… not hedging your crop in today’s extremely volatile market is reckless business practice.

The post discusses hedging agricultural products, but the arguments apply to any commodity. It also suggested a sensible hedging program:

“One can’t lose using a hedging strategy. Especially if, as we always recommend, you hedge only one-third of your crop. The ideal scenario is to sell one-third of the crop on a pre-season minimum price contract and one-third on a pre-season fixed price contract. One can then keep the last third for the end of season premiums, without risking losing good income from the main part of the crop. Read more

Designing an effective hedging program is not easy. It requires a deep knowledge of the hedging instruments that are often quite complex. It also requires a thorough understanding of different hedging techniques and strategies. A specialist can help implement a robust hedging program in this regard.

 Post Source Here: To Hedge or Not to Hedge

Innovations in Derivatives Markets-Free Book

The proceeding of the conference “Innovations in Derivatives Markets—Fixed Income Modelling, Valuation Adjustments, Risk Management, and Regulation” is available for download here.

The main focus of the conference was the topic of derivatives valuation which is a subject of great importance for the financial industry, specifically the rise of new valuation adjustments commonly referred to as “XVAs”. These XVAs have gained significant attention ever since the financial crisis in 2008 when banks suffered tremendous losses due to counterparty credit risk reflected in derivatives valuation via the credit valuation adjustment, CVA. A debate on the incorporation of funding costs in derivatives valuation starting in 2012 introduced a new letter to the XVA alphabet, the so-called funding valuation adjustment, FVA, together with its specific impact in banks’ profit and loss statements. With the conference, we intended to discuss these topics in the light of market evolutions, regulatory change, and state-of-the-art research in financial mathematics by bringing together renowned scientists, practitioners, and ambitious young researchers.

Where Has the Volatility Gone?

A recent post by Bob Pisani pointed out 3 reasons for the low volatility:

1- Thanks to advances in trading technology, the market has become extremely efficient. "With automated traders and news box traders the prices of stocks — supply and demand — is extremely efficient",

2- Exchange-traded funds are reducing volatility because you can trade the ETFs without trading the underlying stocks,

3- The Fed has tamped down volatility for years by keeping rates low and essentially encouraging people to buy equities due to its quantitative easing program.

Regarding  #3, Mallick et al has confirmed:

Our preliminary findings are that an unexpected loosening of monetary policy - through a cut in the federal funds rate in the pre-crisis sample or an increase in bond purchases post-Lehman - typically leads to a decline in both expected stock and bond market volatilities and the term premium. Read more

As for #1 and #2, we are not aware of any research supporting these arguments.

Let us know if you know of any.

How Will IFRS 9 Affect Financial Institutions

In a previous post we discussed how IFRS 9 will affect commodity firms through hedge accounting programs. Generally speaking, as pointed out by Thack Brown in this post, IFRS 9 will affect financial and non-financial corporates through:

1-New classification and measurement principles for financial assets,
2- New impairment models that will accelerate recognition of credit losses,
3-Improved model of hedge accounting.

As we can see, commodity firms and other non-financial corporates will be most affected by the new hedge accounting rule, while Banks and other financial institutions are impacted by the new credit loss model.

To respond to the new requirement, Banks are currently in the process of implementing a new credit loss (ECL) model. However, experts have warned that the new accounting standard will increase the Banks’ revenue volatility and have significant impact on their regulatory capital and provisions.  In fact, early this year, Tom Porter wrote

“Capital headwinds in a downturn could be much more severe under IFRS9,” Barclays analysts wrote in a note on Monday, adding that the changes could knock as much as 300bp off industry-wide common equity tier 1 ratios during a typical downturn. This would be around three times higher than under the current system.


“There will be plenty of instances when IFRS9 appears to smooth bank earnings,” they said. “But in a bad enough downturn – or where there’s a swift enough deterioration in credit quality – the provisions taken in good times won’t be enough to cope.” Read more

To help smooth out the negative impact of the new accounting regime, the Basel Committee on Banking Supervision recently released a statement regarding the regulatory treatment of accounting provisions and standards for transitional arrangements. It said

Given the limited time until the effective date of IFRS 9 (which will take effect on 1 January 2018) the Committee will retain the current regulatory treatment of provisions under the Basel framework for an interim period. This will allow the Committee to consider more thoroughly the longer-term regulatory treatment of provisions. Jurisdictions may adopt transitional arrangements to smooth any potential significant negative impact on regulatory capital arising from the introduction of ECL accounting. Read more

This means that Banks can adopt a transition period, thus allowing them to be able to mitigate the negative impact of ECL accounting, which, according to the previous article, can be as high as 300 bp during a downturn.

Developing and implementing a robust model is not always easy. We believe that after a transition period, the new ECL model will bring more stability to the financial system.

 Article Source Here: How Will IFRS 9 Affect Financial Institutions

Will Subprime Car Loan be the Next Big Short ?

Many investors believe that the next big short will be in the subprime car loan market.

Subprime car debt is becoming the latest problem area in finance, with consumers falling behind on most of their loans, Morgan Stanley analysts said this week. Wall Street banks have become more willing to underwrite asset-backed securities packaging the loans as new regulations brought in after the financial crash make it harder for them to make a profit. Read more

However yesterday Bloomberg reported that car sales are in decline.

Recent history suggests American automobile sales indicate subsequent moves in U.S. equities. Declines in 2011 and 2012 were followed by a retreat in the S&P 500 index, and gains in the fall of 2015 came before a market rally. While the relationship isn’t exact, and correlation doesn’t equal causation, the surprising slump in vehicle sales last month comes just as investors are questioning how much to believe off-the-charts surveys of American confidence levels. Read more

Can these two conditions coexist ?

The Hacienda Oil Hedge

A couple of weeks ago, Bloomberg reported that Mexico will hedge oil prices for the next year:

Mexico plans “without a doubt" to protect the country against low crude prices for next year, Deputy Finance Minister Vanessa Rubio said in an interview, in a continuation of what’s become the world’s largest commodities hedging program. Read more

This is supposed to be the biggest oil hedging program in the world. 

Yesterday another Bloomberg article gave interesting insights into Mexico’s oil hedging program

This is the untold story of how Mexico, as early as 1990, constructed what quickly became the world’s largest and best-­concealed oil trade.

It is, however, interesting to note:

If anything, recent results have made the Mexican government look especially good. The country earned $6.4 billion in 2015 and $2.7 billion in 2016 [and $5.1 billion in 2009]. Read more

So the Mexico’s government consistently makes money from its oil hedges.

Does this look like a hedge?

Hedge Funds Help Dampen Market Volatility

In times of fee pressure, institutional investors continue to use hedge funds. Why ?

There are a variety of answers, but many institutional chief investment officers will tell you they rely on hedge funds to help dampen market volatility and provide returns that are risk-adjusted and uncorrelated to equity markets. Read more

This means that sophisticated investors will use hedge funds to manage the risks instead of trying to beat the market.

Hedge funds in this category often use tail risk hedging of some sort. One hedging strategy is convexity hedging.

The GAMMA hedging strategy is not used frequently in the industry. The rationale for introducing it here is that given a high price of a put option, we will try to partially recoup its cost by actively scalping gamma, while we still benefit from the positive convexity of the option. This means that in case of a market correction, the gamma will manufacture negative delta so that the hedging position can offset some of the loss in the equity portfolio. Read more

Relationship Between Credit Default Swaps and Equity Options

After an increase in volatility, equity markets seem to be going back into the state of calmness.  Additionally, with Easter coming up, volume and volatility are expected to remain low, at least for a couple of weeks.
However, beside the equity world, the credit market is experiencing a tightening as well. The graph below shows the BofA Merrill Lynch US High Yield Option-Adjusted Spread [1]  which is in its lower range since 1998.

Dave Sekera pointed out reasons for the compression of the credit spreads
Much of the tightening has occurred in sectors that are either highly correlated to improving economic conditions or to higher interest rates. For example, in the first quarter, the basic industries sector has tightened the most, as underlying commodity prices have risen off of the early 2016 lows and have held steady thus far this year. Manufacturing has also been one of the better-performing sectors this year. The rise in oil prices has improved the outlook for companies that manufacture equipment used in the oil sector, and the expectation of protectionist policies from the Trump administration has lifted companies that have significant U.S. manufacturing operations. The expectation of rising interest rates has led to outperformance by the finance sector because banks are expected to be able to raise their net interest income margin . Read more
Given the low equity volatility and the tightening of credit spreads, one might ask:
Is there a relationship between the VIX and credit spreads?
Intuitively, there should be;  this is because traders can use long-dated out of the money options as a proxy hedge for credit risks.
Formally, indeed, the relationship between credit default swaps (CDS) and stock options written on the same underlying was proved by the academic community. Carr and al examined the joint movements of CDS and equity volatility and showed that they are highly correlated. The authors then developed a model that prices both CDS and equity options at the same time.
We estimate the joint risk dynamics using data from both markets for eight companies that span five sectors and six major credit rating classes from B to AAA. The estimation highlights the interaction between market risk (return variance) and credit risk (default arrival) in pricing stock options and credit default swaps.
The estimation also highlights the interaction between market and credit risk in pricing stock options and credit default swaps. The default arrival rate affects stock option pricing through its direct effect on the risk-neutral drift of the return process. Read more
Given this relationship, there is no surprise that when the VIX is low the CDS is generally low, as they are right now.
However, it’s important to note that like any relationship in financial markets, this one can break down as well.
 Footnotes
[1]  BofA Merrill Lynch, BofA Merrill Lynch US High Yield Option-Adjusted Spread© [BAMLH0A0HYM2], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A0HYM2, April 2, 2017.
Post Source Here: Relationship Between Credit Default Swaps and Equity Options

Hedging in the Mortgage Backed Securities Market Can Increase Volatilities

Equity markets were relatively calm after the US election.  The recent weeks, however, have seen some increase in volatility. Is this just a blip or the start of a volatile period?

Nobody knows the exact answer. But Gregory Meyer et al of FT.com reported that there are firms, notably DRW, based in Chicago,  that already started betting on an increase in volatility this year.

Mr Wilson, DRW chief executive, says he has been surprised by the lack of volatility in financial markets since Mr Trump’s unexpected election. “There are many things that could happen that could cause volatility to increase”. Read more

D. Wilson cited political risk as the main source of uncertainty. However, beside political risk, another important source of volatility is found in the Mortgage Back Securities (MBS) market.

10 years Treasure Index as at Mar 28 2017. Source: Stockcharts.com

Liz McCormick et al. at Bloomberg explained why the Mortgage Back Securities market could present a potential problem.

Even as the central bank amassed trillions of dollars of debt to prop up the economy following the financial crisis, it didn’t hedge its holdings or worry about gains and losses that might keep ordinary investors up at night. This extreme buy-and-hold stance has had an incredible calming effect on the bond market. Volatility has plummeted to lows rarely seen in recent memory. Read more

In other words, the Fed, acting as a gigantic Buy and Hold investor, has held a tremendous amount of MBS.  However, they don’t hedge their positions actively, thus providing the markets with a subdue volatility.

But remember that there is an embedded option in a mortgage-backed security. It’s called the prepayment option precisely.

D’Ecclesia et al. pointed out that a prepayment option is an option to refinance a mortgage.
Mortgage-backed securities (MBS for short) combine features of both bonds and options. The investor in the MBS has purchased a fully amortizing bond, with known coupon rate and maturity date. However, at the same time the investor has written a call option to the mortgage borrower. The homowner’s privilage to refinance his or her mortgage at any point in time complicates attempts to price the MBS. Read more

Therefore the MBS holder is short a call option, i.e. he’s short convexity.  Banks who originate mortgages usually use swaptions to hedge the prepayment risk.

When the interest rate is low, and the biggest MBS holder is the Fed, the volatility remains low.  However,  when the interest rate starts to rise,  the central bank’s $1.75 trillion position in mortgage-backed securities will be transferred to private investors. This means investors will be shorting embedded call options and they have to hedge. Their hedging activities will likely cause the volatility in the fixed income markets to increase.  And this volatility can spill over to the equity and other markets as well.

 Post Source Here: Hedging in the Mortgage Backed Securities Market Can Increase Volatilities