Hedge risk? As stock market volatility is trading at odd, if not absurd lows, Bank of America Merrill Lynch’s Global Asset Allocation team doesn’t think much of the VIX as a leading indicator and advises to hedge inexpensively. In fact, they think the opposite of low volatility is about to disrupt the dead calm.
Hedge risk – Significant risk exists amid low risk signals from volatility measures
Low trading volumes, tight ranges and “limited directional conviction” has combined to push hedging costs to yearly and in some cases multi-decade lows.
But this calm is a façade, BAML analysts Jason Galazidis, Abhinandan Deb, Anshul Gupta and Benjamin Bowler assert. In a Cross Asset Hedging report titled “Hedge costs at 2016 lows despite markets increasingly susceptible to a shock,” they assert that “fragility event” risk is rising. They think the markets could be headed for a repeat of the August 2015 stock market swoon, one that was linked in large part to the potential for the US Federal Reserve to pull out the needle of stimulus.
Much of the same risk management issues are still in place as concern over interest rate rises in September or December pervade market talk. But this time around there is an added risk of yet another US government debt showdown and an ever present concern over a populist political contagion.
That volatility could change rather quickly, in large part due to populist elections on the horizon. The report noted in the US there is the Trump / Clinton race and in Italy there is the Five-Star Movement will be closely watched. In both cases, plans to inject the real economy with life through fiscal stimulus rather than central banks purchasing financial assets is being closely monitored. Much like elections in the US, Italy’s anti-establishment Five Star Movement is viewed in part as a vote on globalization and a protest vote regarding the current state of politics and elite influence.
It is in this environment laden with risk currently not being represented in the market that BAML wants to hedge.
Hedge risk – Look to inexpensive options for hedging, BAML says, pointing to markets around the world
To consider where to hedge, BAML looks for value – and what is trading cheaply. While the VIX is attractive, their algorithmic screening show opportunity in Asian markets.
“NIFTY (Indian equity market) and KOSPI (Korean equity market) puts continue to rank highest (least expensive) across assets,” the report said. “In fact, the average hedge benefit per unit cost of 2.6 currently afforded by NIFTY puts is the highest we have witnessed in the past year.”
In commodity markets, Aluminum puts are the top screen hedge for cheap options to obtain long volatility exposure to while crude oil puts are the most expensive. The US Dollar / Japanese Yen currency pair ranks as the highest volatility ranking and thus most expensive options as the Bank of Japan is headed into a September 20 – 21 meeting. In this meeting the BoJ could move in any number of directions, including pointing to central bank involvement in fiscal stimulus, which would be a historic first. Against this backdrop, puts in the Japanese stock market are very high.
There are certain hedges that are difficult execute, particularly when a portfolio includes globally diverse assets. For this, the BAML report recommends the MSCI World index, which “offering 40% better value than the median hedge benefit” the fund screens.
In regards to interest rates, the report noted that “rates hedges (swaptions and TLT puts & calls) rank relatively poorly in terms of their consistency vs. other assets in our screen.”