Could anticipated progress in trade talks with the U.S. and China be positively reflected in the markets?
This chart from Garrett DeSimone, Head of Quantitative Research at OptionMetrics, illustrates a recent drop in 30-day implied volatilities in Asian and US options in January, with volatilities decreasing steadily together for each. One explanation for the drop is that it could potentially be stemming from the possibility of thawing trade tensions.
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Implied volatility is a forward-looking measure based investor demand for options and market expectations. “When implied volatility—a measure of expected volatility extracted from options prices—goes up, this is typically associated with market fear and turbulence. Higher implied volatility is a result of larger option premiums,” says DeSimone. “An increase in implied volatility, generally, but not always, forecasts higher volatility in stocks and the markets overall.”
This recent drop may reflect that investors may be optimistic about continued trade talks.
“While no one knows what will happen in the future, we would expect that progress in trade talks would support a continued regime of lower volatility in Chinese markets. Related to this, we think any news regarding future stability in the Yuan would be received well by EM equity markets,” says DeSimone.
Volatility in options in emerging markets tends to be higher due to increased uncertainty and a greater expense in investing in them. “One issue preventing even higher growth in options in Asia is the higher expense due to larger transactional costs for institutions compared to the US. Additionally, implied volatility in Asian options tends to be higher because of inherently greater uncertainty associated with emerging markets economic fundamentals,” says DeSimone. “However, we have seen interest in the last two decades in the Asian options markets. Continued development of this financial sector could further spur growth.”