Cheap Macro Hedges And How VIX Has Always Been A Poor Early Warning Signal

We have time and again pointed to the warning signals being sent from credit markets, FX volatility skews, and equity option volatility technicals (skews and implied correlation) but while the mainstream media is behooven to watching every tick in the 'fear index', the 'simple' VIX has consistently underpriced risk in the face of danger. Furthermore, this implicit optimism, leaves equity options among the cheapest macro hedges across asset classes currently (especially relative to FX, Rates, and Credit). FX options offer the next cheapest hedge with credit already notably stressed. BAML's research group finds Nikkei (Japan), Nifty (India), and ASX200 (AUS) puts attractive as global macro (crash beta) hedges with Copper, IG, and HY credit the least attractive at current levels.

Equity implied volatility is currently screening as the cheapest place to buy protection across asset classes. Throughout 2011, equity repeated its historical behaviour of underpricing risks flagged by other asset classes only to react strongly in sell-offs.

Ahead of the Lehman crisis in 2008, the first round of the Euro sovereign crisis in 2010, and the second round in Aug 2011, equity volatility was consistently among the most optimistic of the cross-asset hedges.


BAML believes this will continue in 2012 and recommend screening for dips in equity option prices to take advantage of this behaviour. Implied risk in FX options is next lowest and also offers, similar to equity, the most potential upside in a severe 2008 style sell-off.



This chart illustrates where the best hedging value is currently across asset classes. 

[the chart above measures the expected relative benefit per unit of cost of owning a put on any asset vs. a put on the S&P 500. This is based on the peak to trough drawdown each asset has recorded when the S&P has fallen by 10% or more in a month and approximates an expected payout ratio.


For example the expected gain from owning a hedge on the Nikkei 225, even under the minimum beta the Nikkei has exhibited to the S&P since 2008, still suggests puts will payoff over 1.5 times as much as S&P puts given current costs. In the best case scenario, they are expected to pay off over 2 times S&P puts.]

Equity put options on the Nikkei 225 (Japan), Nifty (India), ASX 200 (Australia), commodity puts on Aluminium and FX puts on AUDUSD stand out as good value. Aluminium hedges would be particularly attractive for hedging the risk of a hard landing in China or spill over effects from Europe into EM economies according to our commodities research. ASX200 and AUD are also implicit China hedges due to their commodity dependency and AUD is overvalued due to excess pricing of US easing according to our rates and FX teams.

So the next time you hear the VIX is up or down or sideways, treat it with the contemporaneous weighting it deserves (or potentially discount its eternal optimism entirely) and remember that while it is frequently cited, the availability bias needs to be suppressed when investing.


Source: Bank Of America Merrill Lynch


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