European risk has never traded at such an extreme level relative to US risk... ever. But when looking for the best bang for your Greferendum-trading buck - are you better off buying higher vol in Europe or lower US vol? Or, as Goldman Sachs explains below, what are the highest payouts on bets for a rebound...
Europe is pricing significant event risk while the VIX @16 is only 1 pt above its 2015 avg - Europe's "VIX" trades at more than double that of US "VIX" - this has never happened before...
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Impact of Greek crisis on US Economy: Impact via financial conditions not trade
European sovereign concerns have renewed over the course of the month. The outcome of the July 5 referendum in Greece posts higher uncertainty over the future negotiations. In a recent US Daily: Limited Spillovers from Greek Turmoil So Far (June 29, 2015), our US economics team analyzed two of the primary channels that the Greek debt crisis could impact the US economy: (1) international trade flows and (2) financial conditions.
- Channel 1. International trade: Little impact. Our economists estimate that any cyclical spillovers through trade may be small as exports to Greece are less than 0.01% of US GDP. Even a broader Euro area slowdown may have limited impact on US trade as exports to the Euro area only constitute around 2% of US GDP.
- Channel 2. Financial conditions: Intensification of Euro area crisis => Equities down, US 10y lower, dollar stronger. While spillovers from trade may be limited, the impact on US financial conditions could be more sizable. Our economists’ analysis of the impact of Euro area crisis events on US financial conditions between 2010 and 2013 showed that intensifications of the Euro area crisis typically lead to lower US Treasury yields, lower SPX levels, a stronger dollar and tighter overall financial conditions. They estimated that in 2012 the Euro area sovereign crisis, at its peak, shaved about one percentage point off of US real GDP growth. In a recent study they highlighted two primary findings: (1) A hypothetical one percentage point slowdown in Euro area growth could slow US growth by around 0.15% over the next six months; (2) Changes in US financial conditions have sharper effects on US growth with a 100bp tightening in financial conditions slowing our US current activity indicator by about 0.6 percentage points over six months.
Historic VIX move yet the VIX dropped back to 16 and the SX5E/SPX vol ratio is near a 15y high
Prior to Monday June 29, the US equity options markets had been pricing Greece as a non-event. After the breakdown in negotiations between Greece and its creditors and the Greek Prime Minister’s call for a referendum, the VIX finally took notice.
- The VIX: As of Friday June 26, the VIX was at 14; slightly below its average over calendar years 2013 and 2014 of 14.2. Fast forward to Monday June 29th and the GREK ETF which tracks Greek equities was down -19.4%, the DAX dropped -3.6% and the S&P 500 declined -2%. The VIX played catch-up landing at 18.85, up 4.8 vol points on Monday, a 99th percentile event back to 1990. As of the market close Wednesday July 1, the VIX was back to 16.1, exactly one-vol point above its 2015 ytd average of 15.1. S&P 500 10d realized volatility stands at 14.6 and 1m at 11.9
- SX5E vol is at a record high vs SPX: The ratio of EURO STOXX 50 to SPX 1m implied volatility serves as a proxy for the relative short-term event risk being priced in Europe versus the US. SX5E implieds have traded at an average ratio of 1.26x SPX implieds since 2000 (a 26% premium). By last night’s close, the SX5E/SPX vol ratio hit 2x, one of its highest levels on record, and well above the ratio of 1.7x attained during past European flare ups from 2010-2013.
Greece remains unpredictable: 10y Italian & Spanish bond spreads to Bunds may reach 200-250bp
The Greek referendum is scheduled for Sunday July 5 and the outcome of the referendum and surrounding negotiations remains highly uncertain. With Greek equity markets closed, one way to look at stress levels in Europe would be to gauge Italian-German and Spanish-German 10y yield spreads. Ten-year Italian and Spanish spreads to Bunds were recently trading around 145 bp. Goldman Sachs economist Francesco Garzarelli believes that spreads could reach the 200-250 bp range if IOUs are introduced and capital controls remain in place for an extended period. Under a more bearish scenario, he believes that Italian and Spanish spreads to Bunds could widen to around 300bp in the event of 'Grexit'.
And so Goldman asks, are investors better off buying elevated optionality closer to the source of concern (Europe) or buying lower volatility in the US?
Highest payouts under European downside scenarios: European indices offer > 6:1 payouts
Sensitivity analysis: It’s not surprising that European indices show the highest betas to spread widening across global indices. Exhibit 5 shows that the DAX could be down -12.6% per 100bp increase in the 10y Spanish-German spread if the index followed its typical beta to spreads (SX5E: -13.4%). That is more than double the expected shift in the S&P 500 of -4.9%.
Best bang for the buck if spreads widen: After controlling for current option prices we estimate a potential payout of 8-to-1 using FTSE MIB options if the 10y Spanish-Germany spread widens to our economists’ bear case of 300 bp with DAX and SX5E puts offering payouts of around 7-to-1. Under the more modest assumption that spreads widen to 225 bp, our results indicate that investors are still better off buying European indices. Expected payouts on DAX and SX5E are 3.3-to-1, nearly double the S&P 500 payout of 1.7x. There are of course several caveats, the correlations between spreads and equity movements are not high (DAX: - 0.51; SPX: -0.31 over the last year), but that also may imply that under a correlated sell-off we may be underestimating the sensitivities. The US could also trade spread widening as a Europe specific event with European indices reacting much stronger than those in the US, which may argue for sticking with European indices consistent with our results. Expected payouts under 10y Italy-Germany spread widening leads to higher payouts and is shown in Exhibit 6.
Scenarios assuming the DAX moves down another -10%: The beta of the SX5E to DAX returns is 0.94, about 2.4x that of the S&P 500 (0.39) and even after controlling for higher option prices expected payouts using SX5E puts are nearly 1.6x higher than SPX puts. DAX options screen attractive with potential expiration payouts of 3.3:1, FTSE MIB (2.9:1), SX5E (2.8:1), SPX (1.7:1).
While buying high vol is never an easy task, we find it interesting that, at least at this stage, European indices are still screening attractive under a risk-off event. Given higher option prices put spreads may be an attractive alternative over outright put purchases.
Positioning for a rebound? Highest call payouts in Europe.
Our economists (and most investors that we have spoken with) believe that Greece will remain a member of the currency union, but the probability of 'Grexit’ has increased significantly. We have received a number of questions from investors looking for upside exposure, to either play a rebound or to hedge existing shorts.
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Under a 10% up-move in the DAX: As of the time of this writing the DAX is down -9.7% from its ytd high. We estimate call option payout ratios assuming the DAX moves halfway (approximately +5%), or all the way back (+10%) to its high, and each index follows its historical beta to the DAX (Exhibit 8). Under the bullish assumption of a return to the high (+10%) we find SPX calls would have a hypothetical payout of 2.9:1 if the index moves up 3.9% in-line with its beta to the DAX versus payouts of 3.6x for the DAX and 3.2x for the SX5E.
Caveats: All of our analyses assume trades using 1m options. Given the spike in short-dated options, investors may benefit from pushing out in the term structure given that implied volatility term structures are sharply downward sloping in Europe. A Greek resolution may also take an extended period of time, another argument in favor of using longer-dated tenors.
Risks: The maximum loss from buying a put option is the upfront premium paid. The maximum loss from buying a call is the upfront premium paid.
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