Link Between Realized and Implied Volatilities

A recent post by Rebecca Ungarino of CNBC pointed out that the current realized volatility is low. It also said that the low realized volatility is influencing the implied volatility through volatility selling.

“We have a historically low level of realized volatility in the markets. In fact, Q1 was the lowest realized volatility on record since 1965,” Weinig said.

1M and 3M Realized (blue) and Implied (red) volatilities. Source: Yahoo finance

Furthermore, the low levels of actual volatility are easily flowing into the implied volatility measured by the VIX. This is due to what Weinig calls the “excessive” number of volatility sellers in the market, with assets pouring in to ETFs like the XIV, which reflects a short volatility position and has surged over 70 percent this year. Another fund, the SVXY, has risen by nearly the same amount.

“As long as there’s that realized premium from implied to realized volatility, you are going to have vol sellers in the market, and that’s creating very low levels of VIX,” he said. Read more

However, as discussed earlier in the posts entitled Why is Volatility so Low? and Why Is VIX So Low and What To Do About It , we think that there are multiple causes for the low volatility environment, not just volatility selling. These can be

• Realized volatility is low, resulting in a low implied volatility,
• Inflow into equities is increasing,
• Popularity of shorting volatility through VIX ETNs is rising,
• Investors are shorting volatility through options,
• Market makers and sell-side institutions are delta hedging their inventories.

Let us know what you think.

ByMarketNews

Risks Involved When Investing in Exchange Traded Funds

The asset under management (AUM) of the Exchange Traded Fund (ETF) industry has grown substantially in the recent years. From 2007 to the end of 2016, AUM increased from $851 billion to $3.546 trillion. Investors have been enjoying many benefits, especially the low cost, offered by ETFs as a result of this explosive growth. However, there are risks that they are not often aware of. In this post, we are going to present some of the risks embedded in the illiquid and leveraged ETFs. An exhaustive list of all the risk factors will follow.

Investing through Exchange Traded Funds is a good way to access illiquid markets, for example high-yield corporate or emerging market debts. Also, investors can short sell or employ leverage by using inverse or leveraged ETFs. However, besides market risks, there are structural risks embedded in these ETFs that investors should be aware of. They are:

1. Liquidity risk: exotic ETFs are characterised by liquidity mismatches, leverage or both – and it is on these products that concerns tend to focus. In the event of a sell-off in a high-yield ETF, for example, where liquidity in the underlying bonds has all but disappeared, gaps may emerge between the price of the ETF and that of the index it is trying to replicate.
2. Counterparty credit risk: Synthetic ETFs, which are backed derivatives not physical securities, with investment banks as counterparties, also present some issues. In many cases, the collateral the counterparties post to the derivative arrangement bears no relation to the assets of the underlying index being tracked. At times of stress, this mismatch exposes the ETF to credit risk from its counterparties.
3. Operational risks: Leveraged ETFs present other difficulties. Due to the requirement to rebalance leverage daily, investors using such ETFs to match their exposure to an index may find that after three days of market volatility they have not had the gains or losses they expected based on the performance of the index. Read more

In addition to these (more or less) apparent risks, there exist other ones which are less obvious and are caused by the herd mentality. For example, as investors have flocked into smart-beta funds, they increase these funds correlations. When the FED stops providing a “protective put” and market volatility increases, the smart-beta funds will likely underperform, and investors will pull their money out of these funds. This can cause a flash crash, or at least a deterioration of the ETFs' performance. In a long term, these smart-beta funds can lead to other problems, for example:

1. Companies will adjust their accounting to become attractive to these publicly-known factor models.
2. A small number of securities favored by the same academic models will receive large inflows.
3. Prices will rise beyond their fair value, not because these theories are right but because the academic marketing machine keeps inflating their prices in a predictable manner.
4. Quant funds will prey on pseudo-quant funds. Read more

Investing in smart-beta ETFs does not necessarily mean we make a smart decision. “Smart” investing requires careful evaluation of the risks involved and decide whether we can afford to take them.

 

Article Source Here: Risks Involved When Investing in Exchange Traded Funds

Does Buying 50-Cent VIX Call Options Make Sense?

News came out last week that the identity of the mysterious VIX options buyer has been revealed. Mark Melin of Valuewalk reported:

The Financial Times first reported that Jonathan Ruffer, co-founder of a $20 billion London-based discretionary fund manager for private clients, trusts, charities and pension funds bearing his name, “has been systematically buying up derivative contracts linked to an index known as the Vix, according to four people from trading departments at banks who are familiar with the trades.” Read more

JUN 13 VIX Call Payoff. Source:ThinkorSwim

While we have no opinion on the accuracy of the information, nor we know the exact details of the hedging strategy, we think that the Fund is doing the right things because of the following reasons:

1. They execute a hedging strategy, especially in this politically uncertain area. As shown in our studies, hedging comes with a cost, but it will provide a good protection for your portfolio in time of turmoil.
2. They execute an explicit hedge using VIX (an index) options. Explicit hedge is necessary because hedging through portfolio diversification is not enough. Portfolio diversification relies on asset correlations that can change dramatically during a financial crisis.
3. They execute a hedge that is cheaper to carry. Our research indicated that the cost of carry of long VIX calls is less than that of long SP500 puts

In addition to the above points, the article also mentioned, at a high-level,  other hedging strategies of the Fund:

The VIX calls represent a small fraction of portfolio exposure, near 0.1%, but there are other hedged positions in the portfolio, including index-linked bonds and gold, according to the source.

We also think that cross-asset hedging strategies make sense.

ByMarketNews

“The most valuable commodity I know of is information”

In the world of quantitative trading, traders and portfolio managers utilize more and more data these days. So it’s not a surprise that the Economist calls data the “new oil”:

A NEW commodity spawns a lucrative, fast-growing industry, prompting antitrust regulators to step in to restrain those who control its flow. A century ago, the resource in question was oil. Now similar concerns are being raised by the giants that deal in data, the oil of the digital era. These titans—Alphabet (Google’s parent company), Amazon, Apple, Facebook and Microsoft—look unstoppable. They are the five most valuable listed firms in the world. Their profits are surging: they collectively racked up over $25bn in net profit in the first quarter of 2017. Amazon captures half of all dollars spent online in America. Google and Facebook accounted for almost all the revenue growth in digital advertising in America last year. 

What has changed? Smartphones and the internet have made data abundant, ubiquitous and far more valuable. Whether you are going for a run, watching TV or even just sitting in traffic, virtually every activity creates a digital trace—more raw material for the data distilleries. As devices from watches to cars connect to the internet, the volume is increasing: some estimate that a self-driving car will generate 100 gigabytes per second. Meanwhile, artificial-intelligence (AI) techniques such as machine learning extract more value from data. Algorithms can predict when a customer is ready to buy, a jet-engine needs servicing or a person is at risk of a disease. Industrial giants such as GE and Siemens now sell themselves as data firms. Read more

This reminds us of the movie Wall Street that was released 30 years ago. Yes, it was 3 decades ago.

“The most valuable commodity I know of is information”





So is the Big Data old news on the Street?

ByMarketNews

Another Quarter Loss for Metlife

Metlife just reported its Q1 earnings recently,  and it suffered another loss due to derivative hedging this time again. Interestingly, interest rates did not move that much since the previous quarter.

Operating profit beat analyst expectations, but included after-tax net losses of $602 million related to its derivatives portfolio in the first quarter. The prior quarter included $3.2 billion worth of such losses.

As written previously, derivative accounting was to blame for Metlife marked-to-market loss. We hear the same argument this time again, as reported by Suzanne Barlyn

Kandarian cited several factors in response: a rising U.S. stock market, a decline in 10-year Treasury note prices, higher rates for hedges, accounting standards that treat MetLife’s positions unfavorably, plus general “ineffectiveness” all hurt the company, he said.

The “ineffectiveness” alone cost MetLife $139 million, Chief Financial Officer John Hele said. Two-thirds of the losses were “non-economic,” meaning they reflect accounting standards regarding how assets and liabilities are valued, rather than the underlying health of the business, MetLife said.

MetLife’s painful derivatives positions are largely a result of positions it put in place to ensure Brighthouse would be financially strong from a capital perspective, and the spinoff would go smoothly. The company is awaiting regulatory approvals for the spinoff, which are unlikely to happen within the first half of the year, Kandarian said. Read more

But the question is: why are other insurers, who also practice hedge accounting, not suffering losses of this magnitude?

ByMarketNews

Another Weapon of Mass Destruction?

Right after we published our thoughts on ETFs and their impact on the markets

Are ETFs Weapons of Mass Destruction?
Why is Volatility so Low?

CNBC reported that a new leveraged ETF is coming to the market. Its leverage is 4 times the daily SP500 returns

ForceShares has introduced two new exchange-traded funds that deliver four times the returns, either higher or lower, of S&P 500 futures. The ForceShares Daily 4X US Market Futures
Long Fund and ForceShares Daily 4X US Market Futures Short Fund are designed to return 400 percent of the performance of the index.

While such “leveraged” ETFs are hardly new — a plethora of products offer double or triple up or down movements in various parts of the market — this marks the first time a quadruple fund has been launched.

Some market participants worry that the temptation of such outsized returns will be impossible to resist, with dire results possible. Read more

This reminds us of CDO (Collateralized Debt Obligation) squared:

A special purpose vehicle (SPV) with securitization payments in the form of tranches. A collateralized debt obligation squared (CDO-squared) is backed by a pool of collateralized debt obligation (CDO) tranches. 

This is identical to a CDO except for the assets securing the obligation. Unlike the CDO, which is backed by a pool of bonds, loans and other credit instruments; CDO-squared arrangements are backed by CDO tranches. CDO-squared allows the banks to resell the credit risk that they have taken in CDOs. Read more

Can you see what is going on here?

ByMarketNews

Where are the Cheap Hedges for Equity Portfolios?

Last week, professor and Nobel Laureate Robert Shiller came out with a statement regarding the market high valuation. He referred to the CAPE ratio which is at 29 at the moment and is considered high.  However, he also said that the high CAPE ratio does not necessarily mean investors should sell stocks right now.
Still, Shiller makes it clear this doesn't necessarily suggest that investors should sell stocks.
"I'm not saying pull out of the market — I'm saying that it looks dangerous now," the Yale economics professor said Wednesday on CNBC's "Trading Nation." "But it could keep going up." Read more
Shiller PE Ratio as of May 3, 2017. Source: www.multpl.com/shiller-pe/

So the question is, once again, how can investors protect their portfolios at a reasonable price and still be able to participate on the upside?
One solution is to employ a hedging strategy such as the US Equity Portfolio Enhancement Trade that uses listed options.
Another solution is to use a proxy hedge. Such a solution was suggested recently by another academic giant, Jeremy Siegel.
Prominent stock-market bull Jeremy Siegel says the best bet in a severe market downturn may be owning 30-year, U.S. government paper.
“And don’t forget, the long bond is the ultimate hedge against a stock-market crash. If there’s going to be a bad event internationally, North Korea, Europe or whatever, everyone runs to the long bond,” the University of Pennsylvania economist and professor of finance at the Wharton School of Business told CNBC during a Monday interview.
“It’s an insurance policy, it gives [the bond] a premium and a premium means a low yield on that instrument,” he said. “If something happens, they will go up if the stock market goes down 500 points.” Read more
Right now, investors appear fearless as they are pouring money into equities. But they have forgotten that hedging is like buying insurance. And the best time to buy insurance is when we don’t need it. When the house catches fire, it will be too late to buy an insurance policy, or we have to pay an exorbitant price for it.
Article Source Here: Where are the Cheap Hedges for Equity Portfolios?

Financial Market Insurance is Not Hurricane Insurance

In a previous post, we pointed out several reasons why the VIX is so low

There are several explanations. But in our opinion, currently nobody knows the exact reasons yet. However, a consensus started emerging. Several market experts say that volatility is low because of the increase in the short volatility trade through VIX-based ETFs. Dani Burger reported:

While gallons of ink have been spilled on whether the VIX is “broken,” some traders are now suggesting that exchange-traded products linked to the index have a hand in the perceived distortion. What’s more, they warn, their popularity — VIX ETPs have absorbed $700 million this year — could exacerbate a selloff if volatility spikes.

Yet budding evidence suggests that VIX ETPs — a more than $3 billion industry that includes the popular $1 billion iPath S&P 500 VIX Short-Term Futures ETN, symbol VXX — have altered the futures market, and at times indirectly influenced the index itself.

However, there are people who don’t agree

Most strategists believe there are stronger forces than ETPs keeping the VIX low. An accommodative Federal Reserve and European Central Bank, strong earnings, low sector correlation and numerous other positive market indicators have capped pessimism, they say.

It’s difficult to prove that ETPs apply constant pressure that pushes the VIX lower, according to Ramon Verastegui, head of flow strategy and solutions in the Americas at Societe Generale SA. Still, with ETPs looming as such a large market presence, they affect the VIX’s term structure while the threat of a sell-off hangs over the index. When VIX futures move 1 point, typically the VIX spot price moves 1 to 2 points, Verastegui said. Read more

Regardless of the reasons, the short volatility trade seems to be crowded. Therefore, it can have a huge impact on the market in case of panic and everyone wants to exit. Dean Curnutt wrote

The hurricane is not more or less likely to hit because more hurricane insurance has been written. In the financial markets this is not true. The more people write financial insurance, the more likely it is that a disaster will happen, because the people who know you have sold the insurance can make it happen. So you have to monitor what other people are doing.

While Haghani’s statements were focused on the manner in which LTCM-specific trades were seemingly attacked by the market, they remain highly relevant today because the notion that financial market insurance is not like hurricane insurance is broadly applicable. When trades are especially crowded, their unwinding can amplify market moves as investors seek to de-risk in unison. Stable markets not only invite trades that bet on the continuation of stability, they almost force investors to pursue them in an investment climate so deprived of nominal return. Read more

The title of this post, Financial Market Insurance is Not Hurricane Insurance refers to Haghani’s statement above, i.e. unlike the insurance markets, in financial markets everyone can sell insurance, and this can lead to a crowded trade.

Interestingly, from a mathematical point of view, pricing an insurance contract is vastly different from pricing an option contract. The former is priced in the statistical measure, where the latter is valued in the risk-neutral world. But this will be the subject of another post.

Why is Volatility so Low?

Last week, after the French election, the VIX plummeted and started its journey into the low-volatility regime again. Consequently,  volatility selling strategy began gaining traction.  However, FT.com published a warning

Jim Keohane, the chief executive of the Healthcare of Ontario Pension Plan, compares selling volatility to picking up dimes in front of a steamroller. “You are not getting paid a lot in the current market for the potential to get killed. That can happen very quickly,” he warns. Read more

The chart below shows the price of Catalyst Hedged Future Strategy, a fund specialized in shorting volatility

Catalyst Hedged Future Strategy price as of May 2 2017. Source: Yahoo finance

As we can see from the chart, shorting volatility is indeed a game of picking up dimes in front of a steamroller, i.e. when we win, we win small, but when we lose, we lose big.

But why is volatility so low?

We provided some explanations in our previous posts

Why Is VIX So Low and What To Do About It?
Now Is The Time to Hedge, But The Cost of Insurance Can Be Expensive

Recently,  Vineer Bhansali provided more clarifications. According to him, the low volatility is due to the facts that

• Realized volatility is low, resulting in a low implied volatility,
• Inflow into equities is increasing,
• Popularity of shorting volatility through VIX ETNs is rising,
• Investors are shorting volatility through options,
• Market makers and sell-side institutions are delta hedging their inventories.

Of all the reasons above, which one is the most important?

We don’t know the exact answer yet. But what we do know now is that it’s very difficult to time the market turn, therefore it’s important to protect our portfolios by using some inexpensive hedges.  The author also pointed out:

In most cases historically, it has paid to replace outright risk with cheap options, or to perhaps build in some cheap downside protection, even without knowing accurately the timing of the correction. While it is almost impossible to time the corrections, it is equally unwise to be superstitiously short volatility when the dissonance between common sense and market behavior becomes so wide. Read more

We are in agreement with him in this regard.

Article source here:  Why is Volatility so Low?

How Will the FED Cut its Mortgage Backed Securities Holdings?

Tomorrow, the FED will meet again to make the decision regarding interest rates. Most experts expect 2 more rate hikes this year. Interestingly, Brian Chappatta  of  Bloomberg reported that hedge funds are going long treasuries

For the first time since July, hedge funds and other large speculators are bullish on Treasuries across the yield curve, U.S. Commodity Futures Trading Commission data show. The shift in 10-year futures was particularly striking, with the group adding an unprecedented 255,942 net-long contracts as of the latest figures, covering the week through April 25. Their bias is so skewed toward gains that the group is the most vulnerable to a bond-market selloff since 2008. 

Their change of heart came at a risky time. While almost no one expects the Federal Reserve to raise interest rates Wednesday, traders are betting that officials will reiterate a plan to hike twice more this year and potentially deliver further signals on their intention to trim the central bank’s balance sheet. What’s more, the same day, the Treasury is set to release documents as part of its quarterly refunding announcement that could shine light on the prospect of ultra-long debt issuance, which has already sent 30-year securities tumbling. Read more

Along with the issuance of ultra long-term debts, traders will closely watch the Fed’s decision regarding the unwinding of its Mortgage Backed Securities holding. As we wrote before, the unwinding of its Mortgage Backed Securities can increase market volatility

Today, concerns regarding the MBS were raised again, as pointed out by Rich Miller

Such securities can unexpectedly come due early if home owners decide to move or to refinance their mortgages. So, if the Fed wants its drawdown to be predictable, it will have to actively manage its holdings and not just passively accept what happens in the market.

He was referring to the prepayment risks embedded in Mortgage Backed Securities

While the Fed has made clear its desire to rid itself of much of its mortgage-backed debt, it’s not been so forthcoming on how far it wants to reduce its asset holdings overall. Read more

Let’s watch the FED tomorrow