Growth vs Risk

S&P 500 vs. Real yield by VIX
¨ Theoretically to price an asset two major factors that are taken into account are expected yield and expected future growth rate. But in reality there are other factors that too impact the pricing of asset due to factors of supply and demand. Today’s chart looks at the performance of S&P 500 since 1997 overlaid with and a ratio which is the 5 year TIPS yield adjusted by VIX i.e. (1+ 5Y TIPS yield) / (1+VIX)
¨ The yield expected by investors on assets is the sum of risk free rate i.e. yield on government bond and risk premium, the latter is dependant on the risk which is volatility of an asset. Assuming yield as a proxy for expected growth and VIX as a proxy for risk premium we get the primary ingredients to price S&P 500. Though the caveat is that the maturities of government yield and VIX are not comparable. Using two factors we get a ratio which kind of replicates the price level of S&P 500

Men will be men

Check out http://hostmypics.co.za/show.php/84_beckham.jpg.html
Don't miss the last image it is worth a Mona Lisa
Once again thanks to Pranav

Open fly

Check out: http://en.wikipedia.org/wiki/Open_fly
An open fly refers to the unintentional leaving of one's fly unzipped or unbuttoned. It is often considered humorous if a person is caught with his or her fly down.

Your fly is open!
However, the situation is not always seen as embarrassing. Winston Churchill, while at a public function, was handed a note reading "your fly is unbuttoned." Churchill scrawled on the note returning it as "dead birds do not drop out of nests."[1]

Thanks to Pranav

Charts by a 'Ghost'

Chart of the Day: Volatilities and earnings
¨ Today’s chart looks at the 1 month implied volatility and 1 month forward volatility 1 month (1M X 1M forward implied) hence and compares it with the percentage of companies that will be reporting earnings in the first and second months from today. The forward volatility is interpolated from one month and two month implied volatilities.
¨ As the chart shows number of companies reporting earnings in the first month exceeds that of the second month which has led to 1 month IVOL to trade at a higher level than 1M X 1M forward IVOL in most of the cases. The 1M X 1M forward volatilities of Telecom and Technology are currently exceeding the spot one month implied volatilities, though the latter’s level can be attributed to the same number of companies reporting earnings in the second month as in the first month. The largest differences between spot 1M IVOL and 1M X 1M forward IVOL are seen in Insurance, Banks, Industrial Goods and Chemicals in declining order. Larger the difference larger is the expectation of decline in volatility one month hence by the market.

Chart of the Day: SXXP sectors’ risk and return contributions
¨ Today’s chart looks at the last 3 month return and risk contributions by 19 sectors that are part of the broader index, SXXP. The risk contribution is calculated as the product of correlation between sector index and SXXP, weights of the sector index in SXXP and 3 month realized volatility of the sector index. The return contribution is product of weights and return generated over last 3 months by the sector index.
¨ The largest contributors of the risk are Banks, Oil & Gas and Industrial Goods. Though the risk return profile of Banks are in line with the premise of high risk low return, the profiles of Oil &Gas and Industrial Goods are surprising, especially for the latter. Though Industrial Goods risk contribution is 3.39, the third highest, its return contribution has been positive. Retail industry is another industry that has outperformed from risk adjusted return perspective. Chemical industry due to its oligopoly structure has returned positive risk adjusted return.

Chart of the Day: Implied correlations across volatility termstructure
¨ Today’s chart looks at the implied correlations across the implied volatility termstructures of leading indices in Europe. Implied correlation is the ratio of the implied volatility of the index to the weighted average implied volatility of the members of the index. An upward sloping correlation termstructure indicates that in future most of the members in the index might move in tandem, while downward sloping indicates that the participants will be more discerning in picking individual stocks: i.e. going short on some and long on others.
¨ Downward sloping correlation termstructures of UKX, SX5E and DAX show that in coming days the market will try to separate the wheat from the chaff. And the upward sloping termstructure of SMI combined with low volatility indicate that the investors are still seeking recession resistant industries like heath care and consumer staples; these two industries account for 43% of SMI’s weight

Chart of the Day: Open Interest (OI) weighted strikes for Feb expiry
¨ Today’s chart looks at how far the Call and Put Open Interest (OI) weighted strikes of some leading indices is from the spot in percentage (return) terms. The chart is overlaid with the expected move of the underlying as implied by the option volatility. As the OI weighted strike moves further away as compared to the implied move, the number of options going unexercised may rise. In contrast to other indices, the SMI has several in-the-money puts
¨ The distance of OI weighted strike from the spot can also indicate the breadth of the price range expected by market participants and compare it with the implied move. For instance the OI weighted strikes of both call and put for SPX is relatively wider as against the implied move when compared to other indices.

Chart of the Day: Sectoral Volatility Premium – EU vs. US
¨ Today’s chart is a scatter plot of 3M implied volatility premium of sectoral indices in EU and US as against the broader market indices, SXXP and SPX, respectively i.e the differences between implied volatilities of sectoral indices and respective broader indices. In a globalized world the volatility premium across regions if not at par should be trading in a close range. Especially, US and EU being the two most open economies in the world with strong trade relationship should have volatility premiums at par except for anomalies caused due to some region specific issues related to sectors.
¨ Financials sector in EU is trading at lesser premium of 6.4 vols compared to 41.7 vols of the US which reflects the losses accumulated by American banks to the tune of USD 810 bn compared to USD 349bn by European banks; moreover European banks have raised capital in excess of the losses while US banks are still short of USD 239bn. Surprisingly though Materials sector in EU trading is at 27 vols premium as against 8.7 vols in US hence shorting volatility of EU material sector might pay off. Energy and Healthcare are other two sectors that show a dichotomy between volatility premiums in US and EU. EU’s healthcare is trading at a deep discount of 16.4 vols as against US’s 7.1 vols discount. Energy in US is trading at a premium of 12 vols compared to a paltry 2.6 vols in Europe.

Chart of the Day: Credit spreads – IG, XO vs. Financials
¨ Today’s chart looks at the evolution of the spread between iTraxx 5Y IG CDS and iTraxx 5Y Financials and also spread between iTraxx 5Y Crossover (XO) and iTraxx 5Y Financials. These two spreads actually look at the margins a financial company might make by lending to investment grade and lower rated companies
¨ Generally, Financial companies as an intermediary of transactions in an economy borrow at lower credit spread and lend at higher spread. Prior to subprime crisis financial companies made a margin of 15 bps and 200 bps by lending to IG and XO companies, respectively. But recently the spread between IG and Finacials have shrunk to zero levels while the margin for XO is a healthy 800+ bps, there by making lending to IG companies unprofitable and during recession lending to XO gets riskier despite tempting spread margins. Hence to spur lending by banks the balance sheet of banks and financial institutions have to be recapitalized

Chart of the Day: SX5E’s option to stock volume ratio
¨ Today’s chart looks at the evolution of the ratio of option volumes to equity volume ratio of SX5E index since January 2006. The data series were smoothened by taking 20 day averages. We have seen that as the risk averseness among investors rose the option volume too gained momentum. SX5E option volume which was around half a million rose to 2.5 million per day as volatility surged. As the volatility eased hedged positions were unwound and hence the option volume declined
¨ Since the start of this year the volume gained by equity was higher than the gain seen by the options, equity volume rose by 49% compared to option’s 33%. And as the volatility settles within a range the volume might decline further and there by the pin risk will diminish in future expiries

Chart of the Day: SX5E Open Interest (OI) rollovers
¨ Today’s chart looks at the evolutions of open interest (OI) of both call and put options of March and June expiries since March 2nd 2009. The open interest is the sum of the open positions of strikes on SX5E ranging from 1500 to 2500 at an interval of 100
¨ The chart shows that as the market rallied from 1,882 to 2,050 the put open interests got unwound while call open positions were being strengthened as indicated by converging of March expiry put and call open positions. Currently conflicting signals are emanating from the OI evolutions, while the put OIs of June expiry are consistently exceeding that of March expiry, the March call OIs exceeded that of June consistently. This indicates that the rally might just end up becoming the third bear rally since October 2008. Though the positive signal is that the June call OI has risen by 270,000 contracts since the start of March compared to 175,000 increase in June put OI

Chart of the Day: Weighted implied vs. Weighted CDS
¨ Today’s chart looks at the weighted 3M implied volatilities and weighted 5y CDS spreads of leading indices. Though there are options available on indices like SX5E, DAX and others, non availability of similar kind of credit indices with similar underlying make comparison of implied of the index and credit index unfair. Hence to over come the issues of different underlying and correlation, plain market cap weighted implied volatilities and CDS spreads are used to compare the pricing between option and credit markets
¨ The chart shows despite SX5E index’s low weighted CDS spread of 123.7bps the 3m implied volatility is almost at 50 vols, which indicates that option market is pricing is more risk premium than credit market. Similar kind of divergence is also seen in UKX and SPX. While weighted CDS spreads of SPX and UKX are 186bps and 189bps, respectively, SPX’s implied is trading at a premium of 4 vols over UKX’s

Chart of the Day: Sectoral earnings yield vs. 3M implied volatilities
¨ When pricing an asset required risk premium is an important factor. Earnings yield net of treasury yield is a measure of risk premium; for the chart 5 year treasury yield was considered. The risk premium is a function of volatility of the asset hence volatility and risk premium from earnings yield have a strong relationship. As shown in the chart the straight line is best fit line based on historical relationship between 3M implied volatility and risk premium of SX5E. We see that the relationship is linear and has a R2 of a healthy 83%.
¨ Based on this premise we can use the relationship to pick volatilities that are trading rich as against the equity risk premium. For instance Banks despite low risk premium are trading at a vol of 65. Other sectors whose volatilities are trading at premium relative to risk premium are Insurance and Industrial Goods. On the contrary Food & Beverages, Basic Resources and Oil & gas are trading lower volatilities as against equity risk premium.

Chart of the Day: Crude Contango / Backwardation vs. Expected inflation in Europe
¨ Today’s chart looks at the relationship between crude contango / backwardation vs. 5 year inflation expected in Europe by investors. Crude is said to be trading contango when the 12 month crude futures is trading above the 1 month futures and vice versa is termed as backwardation
¨ Bond, currency and to certain an extent commodity markets foretell what can be expected in equity market. For instance inversion of treasury termstructure augurs bear market. In similar vein crude trading in contango means that the inflation is expected to rise in the coming days. In the chart we can see inflation following contango / backwardation with a lag and currently despite contango the expected inflation is on the decline. Sooner or later the expected inflation will start to rear its ugly head which will make investors rotate money from bond into equity

What causes skew in an option?

Though Black Scholes assumes constant volatility across strikes, in reality volatilities varies across strikes. Normally implied volatility is lowest near the spot (i.e. at the money) and rises as we move to the flanks there by forming a convex curve termed as skew. There are many theories that try to offer an explanation for the formation of the skew. The prominent among them is “Crashophobia” by Rubinstein based on Black Monday (October 19, 1987) when Dow Jones lost more than 20% in a day. In this article I will be arguing that skew is more due to lopsided pay off from Put compared to that of Call. This argument is based rather on fundamental concept than on empirical evidence.
An option value is sum of Intrinsic Value (IV) and Time Value (TV) ; TV depends on the volatility and time left to maturity and IV depends on the current spot and the strike i.e. moneyness. Hence broadly option value depends on volatility and moneyness. Following 2X2 matrix looks at the impact of change in price (IV) and change in volatility (TV) on the valuation of Call and Put.

For instance in Quadrant 1, when price as well as volatility increases moneyness of Call is up and that of Put is down while both gain in TV as volatility increases. Hence Call gains from IV and TV while Put’s TV gain is offset by loss in IV. The degree of offset will depend on the amount of change in volatility and price, and the sensitivities i.e Greeks. So are the changes in values of Call and Put in other quadrants.
Based on the above premise we look at the scatter plot of one day change in VIX and S&P 500, the latter in percentage. The data series are from 1990.
The chart above shows that the relationship between S&P 500 and VIX is inverted and strong i.e. as VIX rises S&P 500 declines. This fits well with the risk – return concept if we accept VIX to be a measure of risk premium but Black Scholes assumes that Price is independent of volatility.
Now out of 4,806 data points 12%, 41%, 11% and 36% lie in Quadrants 1, 2, 3 and 4, respectively. When we overlay this scatter plot on the 2X2 matrix we find that Put losing its value due to decline in IV and TV is 41% (Quadrant 2) of trading days since 1990 and Put gaining from both IV and TV is 36%. Hence due to the inverse relationship between price and volatility Put would generate extreme returns compared to that of Call which makes Put riskier than Call and hence sellers of options demand higher premium for Put than Call. Thereby create a steep skew for Put which seeps into the skew that market looks at.

The tale of two VIXes
VIX is an index of implied volatility on S&P 500 which was launched almost three decades ago. VIX is supposed to be a measure of investors’ sentiment and it is similar to Credit Default Spread (CDS) indices. Both, VIX and CDS, are proxies for risk premium.
VIX has been making history recently and on Friday (17th Oct 2008) it closed at 70.3 volatility points which is about 25 vol points above the peak registered during the dot com crash. This means that the current crisis would be worse than the dot com burst, just short of depression as many economists from academia predict. Economists from Investment Banks are a corrupted lot; you can trust them at your own peril.


Who caused this crisis?

Some point finger at Greenspan. It seems to be the case, though the economy sputtered even before the dot com burst the contraction of the economy was just normal course correction. And bubble was more to do with tech sector and not the entire economy. As the following chart shows, the system had ample liquidity as indicated by low TED spread. So the case for rate cut by the Fed and maintain it at paltry 1% for many months is weak. Unwarranted money printing by Fed led to excess liquidity which led to steep fall in risk aversion. I remember a strategist from a British bank saying in Jan 2007 that he expects the spreads of BBB rated corporate to compress by 15-20 bps when the spreads were trading at atrociously low levels of 50-60 bps. Let us just hope that recent liquidity injection doesn’t create another bubble.





NSE VIX
NSE launched Indian VIX in November 2007 and this measure has been averaging around 34.5 vol points and was trading above the American VIX, which is in line with fundamental reasoning that despite many growth stories spun around India, US is still a economic power house (it might be dying) and India has miles to go. But since September, US VIX is trading at a premium as against Indian VIX which shows that the investors are asking for lesser risk premium for Indian assets. This seems to be an aberration at least in short term.



Another point to be noted is that the NSE implied normally trade at discount of around half vol points on average to realized volatility. Implied volatility being about future should have premium over the realized volatility.

Indian VIX seems to under pricing the risk in the market both from relative basis and historical basis.