We have to thank Benjamin Bowler: one month ago Bank of America's "equity-linked analyst" (aka derivatives guy) was the first honest sellside banker to demonstrate, vividly and in no uncertain terms and with lovely charts to boot, how the Fed's "massive manipulation" broke the market. We urge anyone who missed it the first time, to reread his piece from late December (it can be found here) because it summarizes in a few paragraphs about 7 years worth of posts from this website.
Earlier today, BofA's Bowler struck again, thinking out loud what could - and would - happen, if the "central bank puts failed" and many, if not all, asset classes proceeded to disintegrate.
As he put it, "since 2014, risk-off episodes have been typically characterized by short-lived bouts of volatility which mostly remained localized to a particular asset class or region as central banks have been aggressive in their actions to calm markets. In our 2016 Year Ahead we anticipated such instances would become more frequent, with an increased likelihood of global contagion as the Fed embarked on a rate hike cycle, reducing their willingness to intervene at the first sign of stress. Indeed, volatility across asset classes has steadily risen over the last few months with global equity vol and US IG credit spreads having breached their 8yr+ median levels. It remains to be seen whether Draghi’s comments on 21-Jan and further global policy initiatives will suffice to curtail further contagion in the mid to long term.
More importantly, being a derivatives expert, Bowler was king enough to lay out a matrix showing the cheapest ways to cross specific or broad asset "crash" risk, ranking the hedge options by underlying asset and by "richness" of the hedge. As we admitted, while hedge costs have risen across the board to levels last seen during the May-12 sell-off, "FX options continue to offer best value with SEKUSD and EURUSD puts ranking as the top hedges in our screen."
He also calculated that within equities, NIFTY puts continue to stand out, while KOSPI puts also offer good value, on relative basis. RTY (Small/mid-cap US equities) puts are the most attractive DM equity hedge at current pricing, while S&P500 and NDX puts are among the most overpriced hedges across all markets.
The summary chart of the various cheap-to-rich puts is shown below (the methodology of how to read this chart is presented at the bottom of the post).
As he explains, Chart 1 shows crash returns of different assets during historical tail events per unit of current OTM option implied volatility.
We measure tail events by the 10 largest 3M drops since Jan-06 (see Finding cheap hedges: the framework for how we algorithmically identify these events at the end of this post). Ranked by the average, the analysis shows that SEKUSD, EURUSD and NIFTY puts offer most value across asset classes, given the distribution of historical shocks in respective markets.
- SEKUSD puts screen as best value across asset classes as SEKUSD volatility has proven resilient to the recent rise in cross asset vol. It is worth noting that BofAML FX strategists recommend short EURSEK to position for a strengthening Swedish economy. Investors positioned this way may find SEKUSD puts attractive as a hedge.
- More generally, FX hedges (EURUSD, AUDUSD & GBPUSD puts in particular) rank as most underpriced versus their historical drawdowns in our screen, with DM equities and Oil puts most expensive.
- However, even the best value hedge is currently offering less protection per unit price than any best value hedge since Jun-12 – i.e., the top-most blue marker (avg crash return / put vol for SEKUSD) is the furthest to the left it has been in 3yrs+.
- NIFTY puts offer the best value within equities and 3rd best in our universe.
- TLT calls continue to rank as good value despite the >4% TLT rally YTD.
But what if one wanted to hedge against specific risk factors, whether the S&P 500, or Stoxx 50, or Emerging Markets, or China, or Commodities, or Junk bonds, or any other major underlying asset class?
Well you are in lunk: Chart 2 through Chart 9 show ratios of historical crash betas (versus a benchmark) to relative hedge costs (see Benchmark proxy hedging in Finding cheap hedges: the framework for a detailed explanation of the methodology). Whenever a proxy asset does not decline for a given sell-off in the benchmark, this hedge benefit is registered as 0, highlighting the basis risk of proxy hedging.
As Bowler summarizes, for good proxy hedges, look out for:
- Average hedge benefit per unit cost > 1 (better value than the benchmark hedge)
- Closely distributed hedge benefits in past sell-offs (consistency of proxy hedge)
- Min hedge benefit > 0 (low basis risk to benchmark)
So, without further ado, here are the cheapest and most efficient ways to profit from a crash by...
Hedging US equities (S&P500)
Proxy hedging the S&P500 with Russell (small/mid cap US equities) puts continues to screen attractive. In fact – at current pricing – RTY puts would have offered 45% better value than S&P500 puts during the latest sell-off (labelled ‘7’ in the chart below). Moreover, RTY puts would have delivered similar or superior protection to S&P puts in 8 of the top 10 S&P drawdowns since ’06.
One thing to note: Proxy hedging S&P500 with RTY puts screens attractive, with the number of RTY puts which can be bought for the price of an S&P500 put at its 95th 7yr+ percentile. RTY puts would have delivered 1.5x the hedge benefit of S&P500 puts during the Jan-16 sell-off, at current pricing.
Hedging US small/mid-cap equities (RTY)
In the Cross-asset tail hedging section RTY puts rank as the most attractive tail hedge across DM equities. Consequently, RTY puts offer better value protection than any proxy hedge candidate.
Hedging European equities (Euro STOXX 50)
NIFTY puts screen top among proxy hedges for ESTX50 exposure, offering 8% better value than ESTX50 puts on average (at current pricing). However, this isn’t sufficient to justify the basis risk, in our view.
Hedging Emerging market exposure (EEM)
Puts on DJUBS (broad commodity index) would have generated superior protection to EEM exposure in most recent large sell-offs vs. the benchmark puts. In particular, DJUBS puts would have offered 66% better value than EEM puts during the Jan-16 sell-off (labelled by ‘6’ in the chart below), owing to declines on relatively low volatility, that most commodities ex-Oil have have exhibited in recent months.
Hedging commodity exposure (DJUBS)
Proxy hedging the DJUBS commodities index with most assets in our screen brings with it prohibitively high basis risk to be attractive, according to our analysis.
Hedging HY Credit
Proxy hedging HY Credit exposure with most assets is not attractive given the high levels of basis risk.
Hedging the EURO (EURUSD)
With EURUSD puts screening as the second best value hedge across all assets in our benchmark-agnostic screen (see Cross-asset tail hedging section), it is unsurprising that proxy hedging EUR weakness does not currently screen attractive.
Hedging Chinese equities (HSCEI)
While HSCEI volatility has continued to grind higher, volatility on most other equities also increased over the past two months. Basis risk and higher prices of proxy hedges have reduced their efficacy in protecting against HSCEI declines, leaving proxy-hedging
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Here is BofA's primer on how to read the above charts:
Finding cheap hedges: the framework: Method I: Cross asset tail hedging
Our cross asset tail hedging screen compares current put option costs to the magnitude of historical tail events in order to determine which options are most underpricing tail risk.
Interpreting the cross asset TH screen:
- Readings further to the right represent assets that are most underpricing historical tail events today
- An asset with a benefit-to-cost ratio of 2 indicates its options are half the price of an asset with a ratio of 1, assuming their historical tail returns were similar
- Looking across asset classes we perform a cost-benefit analysis comparing the cost of buying out-of-the-money put options to the magnitude of historical tail events, without consideration of hedging benchmarks. Assuming historical tail events represent the potential magnitude of future sell-offs, we look for options that are most underpricing downside risk.
- Tail hedge benefit: is measured by the magnitude of the 10 largest drawdowns occurring over non-overlapping 3-month periods since Jan-06 (Chart 17).
- Hedging cost: is measured by the current implied vol of 25 delta put options (*see footnote of Chart 18). We use out-of-the-money options as we are comparing their pricing of large downside risks. Equal delta options allow for easy comparison across assets.
- High benefit / low cost: The best value hedge is cheap to enter relative to its expected payoff in a tail event. The x-axis in the right-hand chart below maps out this ratio for past events and includes the average payout relative to today’s put costs. Assets with points far to the right are most underpricing historical downside risks and hence represent best value.
Method II: Benchmark proxy hedging
Interpreting the BPH screen:
- A reading > 1 indicates better value in the proxy put option vs. the benchmark
- Small variations along the x-axis mean the proxy has good tracking to the benchmark during large sell-offs
- All readings > 1 indicates the proxy has consistently been a better hedge at current pricing
For investors looking to hedge risk in a specific underlying benchmark, including equity, credit, commodity or currency, it is not only important to consider the cheapest options across asset classes, but also how the proxy asset correlates with the benchmark during times of stress. In severe risk-off events, asset correlations tend to 1 and proxy hedging can become attractive. Proxy hedging does not often work for small declines in benchmark assets due to the basis risk between asset classes.
- Here, we identify options on proxy assets that our analysis shows can help hedge against declines in various benchmark assets, bearing in mind the trade-off between cost savings and tracking risk of the proxy asset.
- Proxy hedge benefit: We calculate how much proxy assets have fallen during the largest sell-offs in a benchmark asset (eg. S&P500, US HY Credit). “Crash betas” are computed based on the decline in the proxy and benchmark assets, respectively since Jan-05. For example, Chart 19 illustrates how the AUDUSD moved during the S&P500 sell-off in Feb-10.
- Relative hedge cost: The current ratio of 3M 25% delta put option implied volatility for the proxy vs. the benchmark.
- High benefit / low cost: Chart 20 summarizes how much the proxy asset declined during benchmark sell-offs relative to current option costs. A reading above 1 is desirable and means that proxy hedging would offer better value than put options on the benchmark, assuming relative asset performance is similar to the past during severe tail events.
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And while the above information is great, and quite valuable, it does beg a simple question: if indeed everything were to crash tomorrow (or the day after) in a systemic collapse that drags down the entire asset universe, then while any of the above listed puts will clearly soar in value, just who will be there on the other side, either to sell them to or at exercise time? After all, the crashes envisioned above guarantee that no banks and counterparties would be left standing.
Which begs the question: is, paradoxically, the best crash hedge not buying but selling puts and collecting the premium now before it all goes to hell? After all if everything collapses, who will be there to enforce contracts and demand that you repay your counterparty, especially if the Fed - unlike in 2008 - does not come to bail you and everyone else out?
Finally, if and when contracts are no longer observed, the only "hedges" left, whether cheap or not, will not be of the paper variety but only the physical type.