Curiouser and curiouser...

Wednesday, June 27, 2007

Is this more than your run-of-the-mill six hour bout of risk aversion? It's beginning to look that way. A number of stars appear to be aligning in favour of a more pronounced drawdown in risky assets. Credit looks horrible, for justifiable reasons, and equities are entering interesting technical territory. Meanwhile, official headwinds to the carry trade appear to be emerging for the first time in quite a while; an English translation of a Nikkei article articulating the detrimental impact of yen weakness is now doing the rounds.

What's interesting to note is that much of the 'valuation gap' between the SPX and the VIX appears to have vanished (in favour of the VIX, of course.) Might this mean that the market is no longer overweight downside, and thus more vulnerable to a steep correction? The 1487 double top neckline should provide critical clues. Whether that level breaks or holds, and whether such action is sustained, could well depend on whether the FOMC sends an overtly dovish or hawkish message tomorrow night.
Market focus remains on the swirling subprime issue and the potential for mark-to-market shockers as we end the quarter. What's interesting is that, as one might suspect given market correlations over the past year, most measures of volatility have risen substantially. VIX, MOVE, and credit spread indices are all back at or near their highs of February/March. One exception is USD/JPY vol, which has lagged markedly despite the historically strong correlation. While the chart below compares USD/JPY 3 month implied vol with the VIX, rest assured that MOVE, crossover, and ABX indices all look a lot more like the white line than the green one.

This is particularly interesting given the personnel change at the MOF and the apparent shift in Japan's laissez-faire attitute towards yen weakness. Macro Man opined yesterday that while such a shift might not alter the destination of the yen, it should alter the path of the yen, introducing more volatile, two-way price action. Given that yen vol has lagged other risk measures, and that there are some Japan-specific reasons to expect volatility to rise, and moreover that some of the yen crosses are starting to approach levels that might kick off CTA liquidation, the investment conclusion is fairly obvious. Macro Man therefore buys $25 million/leg of 6 month 120 straddles (7.5% vol) to go long volatility in the cheapest risk hedge going.
Yesterday's profit-take on the FX carry basket was exceptionally serendipitous, but underscores the value of a beta-plus, rather than simply beta, portfolio. Introducing a filter that only implements the beta position when underlying conditions are favourable can substantially improve investment performance; the FX carry position provides an extremely fortunately-timed example of how.

Posted by Macro Man at 10:34 AM  


I'm interested in that Nikkei article if you want to share :) Thanks for a great blog by the way.

Martin said...
3:32 PM  

I only have an email version, rather than a link. If you send me an email to the address, I can reply with the text of the article.

Macro Man said...
3:39 PM  

Um, what is a beta-plus strategy, exactly?

Dale said...
4:26 PM  

MM - What does the straddle-pricing equate to as percent of strike?

"Cassandra" said...
4:41 PM  

It's my term for a strategy designed to capture risky asset returns when conditions are favourable, but steps away from the market when conditions are unfavourable. A pure beta strategy would always be in the market, regardless of underlyng conditions.

A common criticism of hedge funds is that they are really beta strategies in which case one would not wish to pay the fees associated with having one's money managed by hedge funds.

I don't think that is entirely the case, as the performance returns from various hedge fund indices handsomely outperform buy and hold. One capture the vast bulk of (admittedly post-fee) hedge fund returns, however, via applying the sort of market timing filter alluded to above- hence beta "plus".

Macro Man said...
4:42 PM  

Cassandra, the cost of the straddle is 4% of face, which is about 5 yen. That actually seems quite high relative to the range of the last six months, but obviously the bet here is that if spot goes to, say, 118 over the next month, vol will be considerably higher and there will be a small gain from the delt as well.

It's interesting to observe that the market has scrambled for yen calls today. I reckon that just buying vol achieves the same goal without paying the suddenly-high skew and kurtosis premium for the OTM $ puts.

Macro Man said...
4:47 PM  

Sorry, it was 4.11% of face.

Macro Man said...
4:47 PM  

Thanks....even though retail is buying the dips, given the tail risk, a large move still prevents the attendant vol "crush" one might see in other financial instruments for as the yen strengthens, the "thin-ice" risk keeps the market-makers & natural sellers on their toes honest.

"Cassandra" said...
6:47 PM  

Post a Comment


This commentary is written for entertainment purposes only. Nothing you read on this site is advice or an inducement to buy, sell, or hold any real or hypothetical investment, nor should you construe it as such.