For a few desperate days in March, it seemed that central banks had lost control of markets. Trades that had profited from the largely stable, low volatility market conditions of the past eight years blew up. Market participants scrambled to hedge.
Central banks did manage to assert dominance over markets again, with a new raft of extraordinary interventions. But the drama of March’s sell-off, combined with the continuing Covid-19 pandemic and political risk generated by the approaching US presidential elections, has left caution lingering across most markets.
A JP Morgan report published earlier this month noted that options activity across asset classes had hit historically high levels ahead of one of the most divisive US elections in memory.
The US equity market’s most used index for expectations of volatility, Cboe Global Markets’ Vix, was stable throughout much of the summer — but still well above the extremely low levels that preceded the pandemic.
But that cautious tone is also offset by confidence in the huge stimulus that G10 central banks, led by the US Federal Reserve, unleashed in the spring. Many investors are positioning on an assumption that a Covid-19 vaccine will eventually arrive, allowing an uninterrupted bull run to begin.
“The Fed has shown itself willing to do whatever it takes to support risk assets,” says Alexander Altmann, managing director, Americas head of equity trading strategy at Citi in New York.
“We saw it in 2018 as financial conditions tightened, and again this year. Each time it is as though they peer into the chasm of leverage and things look so bad that they then have to do whatever they can to counter it.”
Caution is still high for now, though. Many investors expect that volatility will be present for the near term, as the boost in US options trading shows. The Fed has backstopped markets effectively, but Covid-19 and the Donald Trump-Joe Biden battle for the presidency still stand to cause hiccups this year.
Benn Eifert, founder and CIO at QVR Advisors in San Francisco, notes that he has also seen boosted demand for options with three to six month maturities in recent weeks. The demand for that range of maturities reflects investors’ uncertainty over the basket of risks that they need to navigate this autumn and winter.
“We are seeing generalist portfolio managers looking at the three to six month range for hedges,” says Eifert. “Usually they avoid really short-dated hedges because they don’t have a strong view on timing.
“But they also avoid one or two year options because the total amount spent on premiums looks large. There has been much less interest in owning longer-term volatility and the market has generally priced in a view that Covid-19 is temporary and in a year or two it’s all going to be back to normal.
“So we have looked with clients at how to own that relatively underpriced longer-term volatility while using some small short positions in shorter-dated volatility that help hedge the position.”
Comfortable with complexity, still wary
One of the most notable derivatives trends of the Covid-19 crisis has been investors’ readiness to get back into complex structures after the initial shock wave of market volatility in March. Some attribute the trend to investors’ greater confidence in the improved credit risk of the banks providing the products since 2008.
The taste for complexity has perhaps been most apparent in the US equity market. But the trend is also observable in other asset classes, such as credit.
Since March, Credit Suisse’s structured products desk has seen its clients willing to enter into trades that capture the basis between the cash bond and CDS markets. They are also receiving demand for structured products that capture an illiquidity premium.
But this recovery is far from a return to bullish spirits. For while investors have proven comfortable with returning to complexity, the exposure they have been seeking is much more conservative. Avoiding default risk is a priority.
“We have seen clients going into safer products and giving up some liquidity,” says James Howard, co-head of cross asset investor products at Credit Suisse in London.
“They are parking their money into proper buy and hold to maturity products, going into the safer end of the spectrum and giving up liquidity to get their desired yield. We can structure that and then hedge out the risk.”
“The negative basis and skew trades that have been popular in recent months are not really that much less complex than products that were common earlier in the cycle,” adds Paul Bajer, head of credit structuring at Credit Suisse in London. “It is more about reducing risk. After the great financial crisis there were lots of complex structured products in the world and complexity is what hurt people.
“This time it is about reducing risk rather than complexity. The popular products are pretty complex but they are the right products for this part of the cycle as they don’t have a lot of default risk. It suits clients’ risk objectives.”
Using the tools at your disposal
For more conservative hedgers, such as corporates, one lesson from the crisis may end up being the usefulness of existing derivatives positions. Starting in March, when market participants around the world made a panicked dash for dollars, banks providing cross-currency basis swaps saw a notable increase in their counterparties cancelling in the money positions. The move proved a quick way to access dollar funding and, despite breakage costs on the swap, less painful than issuing in credit markets.
That trade has tailed off as conditions have calmed. But the tactic’s attraction will still be there in future bouts of extreme volatility.
“We did not see desperation but there was discipline from clients in taking an economic assessment of their positions and also making a decision based on the availability of funds at a given time,” says Marios Paparistodemou, head of rates and risk solutions structuring at Nomura in London.
“In the swap you can monetise an in-the-money position with overnight or intraday notice. At that time the credit market was sliding on a daily basis. So, many preferred to monetise their derivative, as a way of getting funds immediately and avoiding widening credit costs.”
Hedging for disaster
The Covid-19 shock has taught some counterparties how to be more nimble in using their hedges. But on a more basic level it has just reinforced the importance of taking one out, especially for drops as extreme as this year.
For long periods of the past eight years, a winning volatility trade has been to sell options and collect a premium as market conditions slumbered. As some portfolio managers made fortunes on those strategies, it proved hard to argue for the importance of hedging for such a huge market event as Covid‑19.
For Eifert, during the good times, many investors could not see past the high cost of hedging for such tail risk and the fact that such a strategy should be generally expected to lose money over time. What many overlooked is that a tail hedge allows investors to hold on to more of their risk assets during a sell-off, and even rebalance into new risk, and then enjoy more gains from the following rally back. The protection leaves more of a portfolio intact after a market explosion — a message that can be hard to drive home in the later stages of a bull market.
“For several years we have been in a very suppressed risk premium environment where there had been lots of heavy selling of tail risk both from retail investors via structured products and from hedge funds picking up carry,” Eifert says. “While everything was going up there were a lot of inexpensive hedges in the world.
“Clearly, after March, a lot of that tail risk supply blew up and people were forced to get a lot more choosy about their hedges and what really represented good value. But it increasingly became even more important in this environment. So a lot of the very deep out-of-the money hedges that were very attractive pre-Covid got very expensive and the tail hedges were pretty well bid because their sellers were largely liquidated.”
