A critique of Credit Suisse Fear Barometer (CSFB) index (uptd)

Credit Suisse recently launched a fear index, Credit Suisse Fear Barometer (CSFB Index) which the firm expects to replace the most prominent ‘fear’ index, VIX. The idea behind the CSFB Index is to quantify fear by putting a zero premium collar on the underlying asset. This combination trade consists of selling a call option of strike 10% above the spot by receiving Rs. X as premium and buying a put of strike Y% lower than the spot by paying a premium of Rs. X, thereby the initial net outlay is zero. The owner of the combo trade is ready to sacrifice gain exceeding 10% in return cuts the loss to the maximum of Y%. The CSFB Index is nothing but this ‘Y’. The report’s contention is that more the Y% lesser is the protection one is getting hence this is an indicator of fear. Following are counter points that argue against the claim that CSFB Index is better than VIX.

• For the above italicized assumption the counter could be that when Y% > 10% the trader won’t put in a collar trade unless he is bullish since he would be betting 10% upside against Y% downside. We see that the CSFB index peaked before the crisis as the traders were over confident or irrationally exuberant. Hence prima facie the index is not reflective of fear among investors
  
  

• The price of an option is a function of five factors as per Black Scholes and measuring fear just by price is flawed. The interest rate, an often ignored factor, justifiably over short period can’t be ignored when developing an index as the prices are impacted by the prevailing interest rate regime. When interest rate rises and other factors maintain status quo put price declines while call rises. We know that Call = S * N(d1) – PV (Strike) * N(d2) and Put = PV(Strike) * N(-d2) – S * N(-d1) and as interest rate rises PV(Strike) declines hence price of put decreases and that of call increases. And hence for the collar trade the trader might have to go deep Out of The Money (OTM) which increases Y% which in turn leads to rise in the index. We see that though the index is choppy both the index and 3 month government yield trend together. The argument is that though interest rate is comparatively minor factor during high interest rate regime it certainly matters in pricing options
  

Since the index lacks fundamental backing it pales as a measure of fear against VIX. On the contrary the index can be used assess the level of irrational exuberance among investors.

VIX – VXO Spread: Risk appetite & diversification (uptd)

Today’s chart looks at SPX Index since January 1995 overlaid with spread between VIX and VXO. VXO is implied volatility index for S&P 100 index and VIX is for S&P 500; S&P 100 is index of 100 companies and S&P 500 is of 500. Hence VIX will trade at lower levels than VXO as the former has higher degree of diversification than the latter. And investors’ preference for diversification depends on investors’ risk appetite - during episodes of high risk averseness investors prefer diversification hence prefer S&P 500 over S&P 100 there by the spread narrows and we see that during the bout of high risk averseness the spread plunges into negative zone. When risk appetite increases the spread increases and trade above zero as seen during 2005-07. Over the last five trading sessions VIX exceeded VXO which shows that risk appetite of the investors are on rise which is good for the market. Another take from the chart is that despite current crisis being termed as one of the worst recessions since the Depression the retracement of risk aversion has been narrower compared to the ‘V’ of Tech bubble crisis.

Gold, a bubble?

Yesterday, gold closed at USD 1145, the historical high, and the metal over last 12 months has generated a return of more than 50%, outperforming the broader equity market by more than 18%. The following charts look at relationship between gold price and an index that is proxy for gold price, and also evolutions of these two.

Gold is an asset which is primarily used as a hedge against inflation and also as a hedge against crisis i.e. investors seek gold when the risk averseness increases. On the other hand gold is an anathema during strong growth period. Hence price of gold theoretically should be proportional to risk averseness and inflation, and inversely related to growth. Based on this premise an index as proxy for gold price was devised as follows,
Gold Proxy Ratio Index = (1 + rp) * (1+ Πe) / (1 + ge)
where,

rp - risk premium (difference between SPX’s earning yield and 5 year US Treasury yield)

Πe - expected inflation (breakeven from 5 year Treasury Inflation Protected Securities, TIPS)

ge - expected growth (yield of 5 year TIPS)

The scatter plot shows that since August the relationship has deviated from the normal course in favour of gold price hinting that the recent run up seen in gold might be a bubble in formative stage. The line chart too shows a considerable divergence between gold price and the proxy.

Thenkulam Index

From technical perspective market is said to be strong if demand for stocks rises despite increase in stock price and volume declines as the price slides. The following chart shows the relationship between stock price and volume traded in a strong market

In a weak market the relationship gets reversed, volume increases as price declines and vice versa. The following chart shows relationship between price and volume traded in a weak market


Based on these premises a new technical analysis too is developed to gauge the strength of the market which is ratio of % change in price and % change in volume. In strong market the ratio will be positive and negative otherwise

Fine tuning the tool further the Thenkalam Index looks at relative strength temporally; the derivation is as follows
· X = 1 if the ratio is positive (i.e. the market is strong) and 0 if the ratio is negative
· Thenkalam Index = 20 day MA of X – 40 day MA of X

If the index indicates that the market is stronger when the index rises above zero and weaker when the index is below zero (refer to the chart given above)

The following chart shows the difference between 5 day moving average and 10 day moving average. We can see that the market broadly rallies after a spike in the index

Crude's supposedly demand curves

Despite the significance the chart is flawed since demand curve factors price and quantity, and not time.
I am trying to integrate time into demand and supply curve which will most probably result in cyclical pattern from a '8' shaped loop. The second chart is just part of this step

U to W by Keynes

Keynes & shapes of recession

Just few months ago the world was swamped with images of the Great Depression. Thanks to media, each and every one who had access to 24X7 TV networks knew what a recession (if not depression) as financial analyst / economist took extra effort to showcase there awareness on the Great Depression and recession. The resurgent market and reviving economy has taken everyone by surprise and it seems that Keynes has rescued the global economy once again from depression; 70s saw ‘W’ shaped recovery which possibly could have been another painful ‘U’ shaped recession. The chart shows US's Federal deficit overlaid with shaded areas for NBER's recession. It seems that Keynes apart from changing 'U' to 'W' (shape of recovery) has also lowered the frequency of recessions.

Implied vs. Realized Correlations
Today’s chart looks at the 3 month implied and realized correlations of some of the leading ETFs. Correlation is calculated as a ratio of the index implied volatility and market cap weighted implied volatility
Implied correlations of all ETFs’ are greater than 3 month realized correlation the exception being RKH. Implied correlations of pro-cyclical sectors like XLE and XLI are 87% and 88% and with decline of economy decelerating these sectors can be expected to perform well in coming days. Implied correlation of RKH is lower than realized as some divergence is performances by the members of the ETF is expected