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Presenting Five Cheap Mega "Fat-Tail" Insurance Scenarios Courtesy Of SocGen's Dylan Grice

Tyler Durden's picture




 

It is certainly no secret that we live in volatile times. It is also no secret that the global economy is as far from equilibrium as it has ever been courtesy of historic direct monetary infusions from global central banks, which keeps world markets propped up at levels that according to some, are between 75% and 150% higher than fair values. What has recently become obvious is that nobody dares to take on the central banks, and specifically the Fed, as there is now a wholescale effort to destroy all bearish mindsets, whether it is by perpetuating the blatantly illegal HFT infested upward-bias broken market structure, encouraging custodian house wholesale short squeezes, or outright fraud, such as the recently disclosed illegal cash transfers to mortgage servicers, and fake fundamental data disclosure of such accounting monsters as Repo 105, and FASB mark-to-market redundancies. Should all these measures to keep the market rangebound, and hopefully cause an even greater short squeeze, fail, we have little doubt that selling of any assets, together with non-naked shorting, may soon be deemed illegal in the current system's last ditch attempt to keep the broken ponzi regime working. Yet what is certain, is that all of these measure will sooner or later fail. Which means that the most industrious investors are currently looking for ultra cheap ABX-like insurance trades, which have little cost of carry, and which promise Pellegrini-like returns when one or all elements of the Ponzi once again begin collapsing. To that end, we present the most recent "cheap insurance" ideas from SocGen's Dylan Grice, who has compiled what may be the cheaper ways to bet against the central banks in such items as inflation, deflation, bond market blow-ups and instability in the oil market. Here are the suggested trades.

Here is how Dylan prefaces his insurance proposition:

Albert [Edwards] and I have a reputation as bears. And it’s true that we tend to focus on the downside. But that’s because we believe that over the long haul, those who think about risk scenarios - whether precedented or not – are more likely to be prepared for them and to know a good hedge when they see one. So this week I want to explore some insurance ideas around inflation, deflation, bond market blow-ups and oil market instability. If we can manage our downside risks well, the upside will look after itself.

“Hope for the best, prepare for the worst,” goes the adage. It would be nice to think that the crash and near collapse of 2008 was anomalous, unusual and unlikely to be repeated. But a cursory glance at any history book shows how regular such ‘outliers’ are. We wish it weren’t true, but the fact is that bad things happen. Regular readers know Albert and I spend a lot of time thinking about downside risks. We don’t do this because we think we can predict when they’ll happen or even if they’ll happen. We do it because they might happen and the most basic defence against the ‘sea of troubles’ is to be aware of just how outrageous the slings and arrows of fortune can be.

And the following thought can be shared by all those who, for some odd reason, are seen by the broader Koolaid sipping lemmingated crowd (which no doubt was screaming bloody murder in November 2008 and March 2009), as Perma bears:

We have no qualms about being thought of as extreme bears … but the truth is that being realistic isn’t the same as being pessimistic and we’d bet on the prepared realists over the blind optimists every time. If readiness is the first blockade against the unexpected, well chosen insurance is the electric fence. So this week I want to focus on some insurance ideas.

As pointed out previously, prevailing volatility levels are notably higher than during the credit bubble period. This in itself argues that cheap insurance will likely not be very easy to come by.

Luckily, not easy does not mean impossible.

The first core problem facing the world economy, as postulated by the vast majority of market participants, is deflation. Cue Grice:

So what kind of insurance is available? The following chart shows 0% 5y inflation floors for the US and Eurozone. They are priced at 360bps and 220bps respectively. That means that someone fearing US deflation could, by making an upfront payment of 360bps, secure five annual payments of any end year YoY inflation rate below 0%. (Very) roughly speaking, the buyer makes money if deflation averages a rate lower than -360/5 =-0.7% per year for the next five years. Notwithstanding my bias that the long-term tail risk is inflation rather than deflation, there is undeniable deflation risk in the next few years (see below). But that looks incredibly pessimistic to me. In fact, I thought it looked too good to be true and that it couldn’t be a real price. But I only came across the idea during a trip to Scandinavia a few weeks ago when one of our salesmen was looking for a seller of the European CPI floors … (willing sellers make yourself known and I’ll put you in touch with him).

It is not surprising that with the prevalent mindset being on deflation as the primary risk, such deflation insurance is rather expensive. So maybe looking half way around the world will present some better opportunities. To Grice, that may just be the case: "In my opinion, the biggest deflation risk is of a hard landing in China. Without going into too much detail, some of the bubble-warning lights are flashing – the explosive credit growth (which Taylor and Schularick have identified as the best predictor of future financial crises), the soaring land prices (nearly 80% annualized in parts of the country with price-to-rent ratios of 30 times, according to Wu et al from the NBER), and the increasing ‘this time is different’ feel."

So how does one isolate the Cheap insurance on a China crash?

According to this armchair psychologist theory, the ‘equilibrium’ level of volatility will be a constant and the best guess of this unobservable constant will be market volatility recorded over as long a period as possible. So the answer to the original question “is equity insurance expensive because it’s higher than it was before the 2008 crash?” is “not necessarily.” But the annualized volatility of the S&P going back to 1964 is around 16% (its 14.3% going back to 1881!) suggesting the current 6M implied volatility of about 23% is rich. A similar picture is true in Japan and in Europe. So while it’s reasonably certain that in a Chinese hard landing scenario, world equity markets would take a bath, the downside protection is too expensive. However, that doesn’t mean all downside protection is expensive. Hang Seng volatility since 1964 is 28.5%, while the 6M implied volatility is only 21%. And given Hong Kong’s cleaner exposure to China, this looks like a better place to look for downside insurance.

We certainly agree with Grice, that while deflation/deleveraging is currently raging, it will be merely a temporary phenomenon. Sooner or later, the deranged Fed will do something so idiotic to spark not outright inflation, but loss in the entire current monetary system, sometimes called hyperinflation.

One place where one can find cheap insurance to monetary instability on the upside may be in Silver ATM Implied Vol versus Realized Vol:

Another place might be in the commodity markets. Silver is thought of as ‘poor man’s gold’ and it certainly has some of gold’s monetary attributes. Fundamentally though, it’s an industrial metal, its price being largely swung around by the industrial cycle. The following chart shows current implied volatilities for three-month options to be marginally lower than the average realized volatility since 1970 of 35.5%. The chart also shows the 3M 25d put priced with an IV of 30.9.

Which brings us to the most prevalent and underappreciated risk: the credit bubble implosion. Is there a cheap way to hedge for that one moment when the Fed loses control of the world's biggest market? It appears there may be.

One of the recurring themes on these pages over the last year has been that our governments are insolvent. This strongly implies a longer term inflation – not deflation – risk. However, long before we arrive at an inflationary outcome where central banks are persistently  monetizing government deficits, we’d see bond market distress of a type we’ve recently glimpsed in Europe. Unfortunately, we don’t know when that’s going to happen because we have no way of knowing when the market loses confidence in a government’s ability to fund itself.

In Japan’s case we don’t know when the retirees drawing down their assets will affect the government’s funding ability; in the US we don’t know whether or when the Chinese will lose their appetite for US bonds (though some FX observers watching the Japanese struggle to contain the yen’s advance are arguing they already have); in Europe we don’t know if the EFSM aimed at bailing out the peripheral economies will be robust in a renewed market panic. All we do know is that it has the makings of an ugly situation and that if we can protect ourselves against it at the right price we should.

The following charts show some of the swaptions market IVs compared to historic volatilities for US and Japanese rates and on this basis both look cheap. However, for the real blow-up scenarios we’d want to go further out of the money and look at payouts for particular interest rate scenarios. Our derivatives guys tell me that in Japan, for example, there are attractive multiples available with payouts of seven/eight times invested premium on offer for scenarios where 10y yields go beyond 4%, but that’s outside the scope of this week’s note. Suffice to say that if the basic IVs look attractive, the more out-of-the-money options might too.

And lastly, with the biggest daily geopolitical risk factor being obviously the festivities coming out of the middle east, the last asset class that is in dire need of cheap insurance is oil. Grice summarizes this risk factor as follows:

there is a possibility the Israelis will eventually attempt to thwart Iran’s nuclear ambitions, as they acted against Iraq in 1981 and against Syria in 2008. Since most intelligence reports suggest Iran is now six to 12 months away from having nuclear warheads (which may or may not be accurate, but Israeli hawks will argue that it has to be treated as though it is), there is a window in which to strike, and that window is now.

All of these seem like attractive entry positions into cheap insurance plays, which will pay off in droves should the black (or gold, or oil, or China) swan strike. In some ways holding a basket of all these trades should make one immune to fat-tail risk. We will continue looking for comparable cheap insurance plays and presenting these, as the moment of unwind of the current fake (dis)equilibrium is certainly getting closer with each passing day.

 

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Mon, 09/27/2010 - 12:58 | 607423 spinone
spinone's picture

Force Majure

Mon, 09/27/2010 - 13:23 | 607469 Cognitive Dissonance
Cognitive Dissonance's picture

Exactly. When the powers that be have been pumping away in the name of apple pie and Chevrolet, anything done by those supreme powers and the resulting consequences can't be held against anyone. Its just an act of God/State, Force Majure and all. Thus all consequences are null and void. Like a tornado. Yeah, that's the ticket. What ya gonna do about it punk?

Same idea as Obama declaring an American citizen persona non grata and a terrorist, thus he's to be killed on sight. Ask for a list of actual charges or even an open court session to determine what this person has done and you are told.........

"Daddy knows best. He's a bad guy because we say he's a bad guy. And since we're Daddy, you my dear slime ball judge have no right to question Daddy. BTW, if you insist on allowing this to proceed, you'll be declared a national security threat and thus a terrorist. How does that blow your robes judge?"

Circular logic backed up by the police state. Works every time. Now shut up and bend over.

Mon, 09/27/2010 - 13:08 | 607442 traderjoe
traderjoe's picture

This assumes that your counter-parties will pay you, the markets will be open, there will be no bank holidays, AND that you can turn any profit into a hard asset in time to watch the dollar collapse from the sidelines (with some popcorn). 

IMHO (maybe not so humble), a significant market crash will mean that the Fed has lost control. They will not be able to stop the resulting global tsunami of debt defaults. And that means your profits will be illusory. 1 quadrillion of derivates will 'poof' into thin air...

As frequently said on this site, PM's are the only money with no counter-party. Productive land, perhaps some apartment buildings (at least some store of value), PM's, useful skills, and stores of necessities...

Mon, 09/27/2010 - 13:11 | 607454 LeBalance
LeBalance's picture

Exactly the comment I was coming to leave.  Why waste all that precious (haha!) time and effort and leave out the last part of the job: calculating the probability of a get away.

Probability: Low.

Mon, 09/27/2010 - 13:48 | 607566 Vampyroteuthis ...
Vampyroteuthis infernalis's picture

trader, you have a good point. They are never going to pay on those contracts. When the SHTF occurs, what is going to stop the gubimint from rewriting all of the rules in their favor? Something similar to what Roosevelt did in 1933 through seizing available gold.

Mon, 09/27/2010 - 14:11 | 607654 The Alarmist
The Alarmist's picture

Yep, all along I was also thinking, "assuming your counterparty survives and honors its commitments."  You could take out a CDS as insurance against the failure of your counterparty, but in this era of bailouts there are no defaults and therefore no actual insurance to cover not receiving the payment you will never receive, and you, like a "secured" Chrysler creditor, will find yourself being stuffed in the name of the greater good of someone's political supporters.

 

Mon, 09/27/2010 - 13:07 | 607445 totalinvestor.com
totalinvestor.com's picture

Yes big potential problems, but what are the solutions. Gold/silver? VXX? So far one has made me money but not the other.

Mon, 09/27/2010 - 13:08 | 607448 37FullHedge
37FullHedge's picture

The Financial markets looks like to me, A bunch of seven year olds in a room full of fireworks and playing with matches, Its a no brainer its going to blow up some how,

I have never played with options however I agree such type of insurance is worth looking at.

My play is boring silver gold some physical and some physical etfs, Silver should be fine if things dont blow up, and gold if things do blow up,

I have some small positions in China but if it blows up no worrries and if it dosnt I have a bit of the pie, My insurance is my smallish position.

To be honest I am lost with things, The return of my money is top of my list at this time. 

 

Mon, 09/27/2010 - 13:15 | 607461 Species8472
Species8472's picture

Nice, but what can I do, using an online broker?

Mon, 09/27/2010 - 13:22 | 607478 Cognitive Dissonance
Cognitive Dissonance's picture

The poor man's insurance.

Gold and Silver held in physical form.

Mon, 09/27/2010 - 13:41 | 607534 tmosley
tmosley's picture

Not just for poor men.

Mon, 09/27/2010 - 13:49 | 607570 Vampyroteuthis ...
Vampyroteuthis infernalis's picture

Poor men can't afford silver and gold.

Mon, 09/27/2010 - 16:18 | 608077 MrSteve
MrSteve's picture

Poor men can walk into any neighborhood coin store and buy a junk silver U.S. 25 cent coin, called a "quarter". Note that you will really be poor if you don't have one or two these set aside for a rainy day. Junk quarters sell in quantity for about $4.25 each, more for small lots numbers. Factor that street price into your calculations for what is happening to the US Federal Reserve Note in your wallet.

Mon, 09/27/2010 - 16:44 | 608169 Cognitive Dissonance
Cognitive Dissonance's picture

I use this as an example with my clients, most of whom are old enough to remember when their pre 1964 quarters were made of 90% silver. I first ask them how much they think the silver was worth when the coin was minted. They pretty much all agree that it was less than the 25 cent face value. I then tell them that today the silver content alone of that 1963 quarter is worth more than $4.00

Suddenly they understand much better what I'm talking about when I say that the price of silver and gold isn't going up, but that the "value" or spending power of their dollars is going down. You see a lot of eyes opening up when you use this example.

Mon, 09/27/2010 - 13:55 | 607594 chinaboy
chinaboy's picture

Kind of disappointed that deep thinkers don't really have good strategies here.

Sun, 03/13/2011 - 22:32 | 1048281 ManOfBliss
ManOfBliss's picture

What did you want specifically? The play couldn't be easier.

Just go physical, and stop pulling paper tricks.

Mon, 09/27/2010 - 14:04 | 607631 THE 4th Quadrant
THE 4th Quadrant's picture

Unfortunately, we don’t know when that’s going to happen because we have no way of knowing when the market loses confidence in a government’s ability to fund itself.

I know. And it's not about confidence. The bond market will never be allowed to unwind in any other way than it's masters allow it to unwind. You can bet your Kuggerrands on that.

Mon, 09/27/2010 - 14:11 | 607653 Tic tock
Tic tock's picture

with an online account, you wait - don't try to catch the top, unless youo're readfy to pull out if you're wrong.. when the fall starts it'll last a few days at least and more imporantly, it'll be heralded by a significant development in the credit markets.. unmistakeable. till then just wait - check in once a day to see what's happening, or you're seriously, seriously risking the capital..! then, choose a sector, find an inverse etf - if shorts are still allowed, better still in an etf not quoted in dollars, and hope the gyrations don't milk you too much

 

Mon, 09/27/2010 - 14:30 | 607709 Bankster T Cubed
Bankster T Cubed's picture

how about you do the opposite?

or better yet, how about you take your money OUT OF SECURITIES MARKETS altogether because the criminals rigging them are leaving only one ending scenario:  total elimination of them in a "one bad day" collapse that takes them to zero and ushers in their new design for the world financial and political system.

 

Mon, 09/27/2010 - 20:45 | 608660 Occams Aftershave
Occams Aftershave's picture

I'm expecting major disruptions, but tell me why these criminals rigging the markets would want to destroy their own net worth ?

Mon, 09/27/2010 - 16:21 | 608088 Djirk
Djirk's picture

What is the bi-flation trade? Commodities up? MBS down?

Mon, 09/27/2010 - 18:14 | 608396 GoldbugVariation
GoldbugVariation's picture

* UK market (FTSE100) puts - not expensive and potential for extra alpha if $ falls vs. GBP as that is bad for FTSE100 stocks (mostly multinationals with earnings reported in GBP).  But, if commodity prices rise denominated in GBP (especially oil) then FTSE100 may not collapse as it comprises at least 20% oilcos and also miners.  So combine this one with oil calls.

* Ultrashort treasuries ETF - like buying yield - low risk because it is currently priced so low, downside limited, plenty of upside potential

Mon, 09/27/2010 - 23:15 | 608963 Hot Shakedown
Hot Shakedown's picture

Is this not a 'dated' point of view? re: oil, Iran? 

 

With Citi, Goldman and 2 other US banks setting up shop in Iran, how will the Israel "effect" ever have any teeth?

Tue, 09/28/2010 - 02:32 | 609252 Grand Supercycle
Grand Supercycle's picture

S&P 500 FINANCIALS INDEX - an important chart:

http://stockmarket618.wordpress.com

Tue, 09/28/2010 - 11:01 | 610081 pocatello
pocatello's picture

I don't get it.  I enjoyed this article, but I have to admit that it is way over my head.  I don't know how to profit from these ideas.  I invite explanations on how to make these trades.  Thanks.

Fri, 10/01/2010 - 16:50 | 619300 pocatello
pocatello's picture

Can anyone explain how to profit from these trades?

 

Or even simpler... how do you execute these trades?

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