Tuesday, June 21, 2016

Markets : Brexit - Positioning Under Uncertainities

There are plenty of research notes and opinions around the possible outcome of and how best to position for Britain's upcoming EU referendum on Thursday. They vary from quite pessimistic to quite bullish on Sterling Pound and other risks assets. This piece does not intend to add to that crowd. I do not posses any special knowledge or skills to prognosticate a voting outcome. However, with that in mind, here are few points to note.

Firstly, positioning for the referendum is much less of an issue if it is for hedging. You really do not need to worry about picking a direction. It is about taking the position that reduces risk exposure of existing portfolio. The decision is then to design hedges that are cheap. I have written about some options a while back.

However, for a speculator, positioning for the referendum necessarily means picking a direction and hence having an opinion on the outcome of the vote - which is inherently uncertain. (This is also applicable for volatility trading, or anything else - here the direction is on the second order than underlying for vol trading). But even if you do not have a strong opinion on the possible result on Friday, a few consideration can help to form ideas about potentially profitable positioning.

And that mean picking trades based on 1) subjective probability (or expectation) 2) market prices (implied or average market expectation) and 3) opportunity costs. 

The first two are pretty intuitive and commonly practiced - basically compares what an investor expects the price distribution to be based on different outcomes, vs. the actual priced-in distribution. This is essentially a relative value analysis in a broad sense (which usually means a pair strategy in the narrow sense).

The third one, i.e. opportunity costs is arguably the most important consideration for decision under uncertainties. In the context of the referendum, let us assume that we have happened to choose to position of short risks. If the outcome is Brexit, our position will be profitable. But if it is not, we will lose on our short positioning. Worse still, if you assume that given the recent rally in risk assets, the upside is limited, then before we square off and initiate a long position, it is already too late. The upside from Bremain is a relief rally for status quo. The market will adjust upwards quickly and find a stable level. 

Now consider the reverse. If you are long and it is a Bremain outcome, again we are in luck. However, the opposite outcome is not same as before. A Brexit outcome will cost us initially. However, a Brexit outcome is far more uncertain than a Bremain outcome, and it is very difficult for risk markets to quickly price in all the consequences and find a proper and stable equilibrium very soon. We will have initial drag from our long position, but plenty of time to reverse that and catch the down-drift. 

The explicit assumption here is that from current levels, upside in risks assets are not great and market is more likely to find a stable levels on the upside than on the downside relatively quickly. If this assumption is correct, an analysis of opportunity cost tells us we should have a bias for long positioning.

In addition, the outcome of Thursday's vote will surely have a binary impact. I have written previously about how one should think about distribution when facing a binary outcome. If we believe in the assumption on the market dynamics above, along with the assumption of a binary outcome, we should base our estimates of the first point, i.e. subjective probability, on these assumptions to be consistent. These two assumptions gives rise to an asymmetric bi-modal distribution. Such a distribution will imply a thinner tail for upside outcome along with a heavy-tailed downside. Statistically this means on the upside we will have single jump probability, but multiple jumps allowed on the downside.

Practically this means we cannot use a single volatility model to price across the strikes on both sides of the at-the-money level. This also implies there is no realistic meaning of skew or vol-of-vol parameters as under these assumptions. The volatility dynamics are very different on the two sides and a single group of parameters valid across strikes on both sides does not make much sense. We essentially have to think about two sides as two parallel realities and combine them to arrive at a subjective price and then compare this to what the market is quoting.

Tuesday, June 14, 2016

Trade Ideas: Cheap Brexit Hedges

The Brexit noise and fear in the markets are getting ever louder. Handful of opinion poll results have led to extreme volatilities in currency and equities markets. It is something that no longer can be written off and hoped against. Unfortunately for investors, hedging such a macro event is neither easy nor cheap.
This blog discussed about a cheap Brexit hedge previously, here we take a more systematic approach.
Hedging macro event such as Brexit involves defining scenarios and associated outcomes in terms of market variables in each scenarios, and then picking the outcomes we want to hedge against. Then it becomes an exercise in balance between the cost of hedges and the residual risks (including basis between investor portfolio and hedge as well as the risk of the particular scenario/outcome assumed not realizing). Defining expectations about scenarios and outcomes of a such an uncertain event is not straightforward. Beyond economic analysis, what matters most in near terms is what market participants perceive as the possible impact, and also what they expect others to expect as possibilities - and make the most out of it. The resulting outcome can turn out to be quite different than what is based on pure economic outcome. However, at present, it is generally agreed that in the event of a Brexit, sterling pound will sell off considerably.
Taking this as an anchor, we analyze cross asset markets for their correlation (rolling weekly) to sterling pound. The figure below shows the outcome. On vertical axis, we have the correlation to sterling pound (GBP) in percentage point. On horizontal axis we have the relative rich/cheap position of each asset (z-score since 2014 beginning). If our assumption is right about a GBP sell-off and if these correlations hold, to hedge positions one would short the assets on the top half and go long on the bottom half. Also from relative value point of view, you want to short assets as far to the right as possible (rich) and reverse for longs. Hence the ideal hedging assets will be diagonal from top-right to bottom-left.

The motion chart captures time evolutions of these correlations. Drag the slider to the latest date. As we can see the most effective hedges (apart from shorting GBP/USD of course) is shorting GBP/EUR. However, in terms of cheapness the GBP 5y cross-currency basis swaps fares much better. In equity space, shorting FTSE vs. EM is attractive too. In rates space the best is shorting USD vs. EUR  10y swap rates (pay EUR swaps). On the bottom half, the best hedge is long euro FX volatility.
Looking around, to position for upside, shorting FTSE vs. Euro Stoxx looks quite attractive.
The trades here:
#1: long calendar spread in Euro FX straddle: discussed in more details here.

#2: short EUR 10y vs. USD in swaps: With Germany 10y hitting negative for the first time, there is very little scope of move further down here. On the other hand, in the event of an actual Brexit happening, any substantial margin calls can transmit risks asset selling pressure to safe assets. This appears more true as it does not look like there is a high amount of defensive positioning around the event. And given the expected tight liquidity in such a scenario, this can very quickly lead to a significant sell-off in euro rates. On the monetary policy side, a Brexit will definitely push down US yields further, pricing out any Fed hike (or even active easing). ECB, on the other hand has little traditional room to push rates down. My theory here is that a policy rate cuts has much less latency in market reaction than asset purchase can ever achieve in a stressed situation.

#3: short GBP short term (2y or 5y) cross currency basis swaps. In  the event of a Brexit, potentially we will have a significant demand in USD funding from UK players. In fact a more risky version of this trade is to short GBP basis vs. EUR. The former is trading far richer compared the later. And presumably given the cross-border exposures of UK to Europe, we may see a significant spike in euro demand as well to fulfill near term obligations of UK financials institutions.

Equities do not offer much attractive hedges after the recent sell-off (although shorting FTSE vs. EM equities can be considered). Equities however offer more attractive upside positioningfrom these levels (see above).

1. All data from FRED database/ Bloomberg
2. Symbols Key in the Chart - GBP10Y: GBP 10y Swaps, GBP5S30S: GBP swaps 5s30s slope, GBPBS5Y: GBP 5y cross currency basis, EURBS5Y: EUR 5y cross currency basis, GBPMMSPREAD: GBP 1y1y money market vs. libor spread, FTSE: FTSE100, VIX: CBOE VIX, GBPEUR: GBP/EUR cross, GBPJPY: GBP/Yen Cross, PERIPHERAL: Germany/Italy 10y bond spread, INFLATION: GBP 5y breakeven inflation, EURVOL: EURUSD 3M Vol, USDEUR10Y: USD/EUR 10y swap spread, GBPEUR10Y: USD/EUR 10y swap spread, USDGBP10Y: USD/EUR 10y swap spread, USDGBP5S30S: USD/GBP 5s30s Spread, USDEUR5S30S: USD/GBP 5s30s Spread, FTSEEU: Long FTSE vs. Euro Stoxx, FTSEUS: Long FTSE vs. S&P500, FTSEEM: Long FTSE vs. MSCI EM Index.