Portfolio Hedging: Risky Assets vs Safe Havens

The credit crunch changed the game and we all know it. Financial markets have been completely reshaped, in fact, the old way to invest is not yielding the results it used to and the composition of market participants have been totally revolutionised (perhaps permanently). The attention towards the management of portfolio risk augmented dramatically soon after the 2008 – 2009 and words like “safe havens” and “risky assets” started to consistently appear on many financial newspapers; but how the “safe havens” relate to “risky assets” nowadays? Which markets can today still be considered to be “safe”? The continuous weekly analysis of inter-market relationships that we perform, here at HyperVolatility, brought us to write this research. Let’s proceed with order.

Risky assets are all those markets that are traded mainly for speculative purposes so in this category we primarily find equity indices (S&P500, DAX, Dow Jones, FTSE100, Nikkei225, etc), stocks (Apple, Microsoft, Amazon, etc), some currencies (essentially Euro vs US Dollar and Yen vs US Dollar) and the most popular commodities such as WTI Crude Oil (this list is far from being exhaustive). Clearly, some of the aforementioned markets are more prone to speculation than others because of the nature of their market players (for instance equity indices are mainly traded by hedge funds, banks and retail traders whilst WTI Crude Oil is traded even by large commercial players that enter futures or options positions purely to hedge their physical exposure) so the way they move and react to market news and changes in the fundamentals vary vastly. On the other hand, the “safe assets” are the ones that fund managers and traders use in order to limit losses during sharp retracements in equity indices. In other words, they are employed in portfolio management as a sort of insurance. The markets that have historically played this role are Gold, Japanese Yen, US Dollar, Swiss Franc, Treasuries such as the American Treasury Bond or the German Bund and the “more recent” VIX Index (the adjective “recent” refers to the fact that the VIX Index could not be traded in the past). The reason they are called “safe havens” is because they tend to rise when risky assets fall, consequently, they are inversely correlated to equity indices and stocks; but is it really so? Do they really provide a valuable parachute against crash landings?

In order to answer the above mentioned questions we take 2 risky assets, E-Mini S&P500 and Crude Oil futures, and we compare their fluctuations against American Treasury Bond futures, German Bund futures, Gold futures, Japanese Yen futures and the VIX Index (the weekly analysis of all the aforementioned markets is covered by the HyperVolatility Forecasts service, send us an email at to know more). The study of the inter-market relationships has been performed using the correlation analysis and the dataset consists of weekly data for the years 2010, 2011 and 2012 (the last observation for the 2012 has been registered on the 24th of August 2012). Let’s examine E-Mini S&P500 futures:

As we can clearly see from the above reported chart the American index is negatively correlated to all the “safe havens”, which means that while E-Mini S&P00 futures were retracing the safe assets were going up and vice versa. Nevertheless, the correlation index fluctuated a lot throughout last years and the fact that Gold and Japanese Yen futures show an incredibly strong positive correlation in 2010 proves what it has been just stated. Therefore, any hypothetical fund manager or trader willing to hedge any S&P500 long position with these instruments would have obtained fairly poor results in 2010. However, it is worth noting that in 2011 and 2012 the futures on the Asian currency performed fairly well and proved to be moderately good when offsetting the risk coming from long positions on risky assets whilst gold futures worked out well only in 2011. Additionally, the futures on the German Bund had a fairly good negative correlation in 2011 but the performances registered in 2010 and 2012 are not really encouraging which means that there were extended periods of time where both instruments (E-Mini S&P500 and German Bund futures) were moving in the same direction. The same thing can be said for Treasury Bond futures, which display a more solid negative correlation in 2012 than German Bund, but the overall performance is still not that good. The only market which showed a constant and reasonably robust negative correlation with E-Mini S&P500 futures is the VIX Index that can be traded via VIX futures and options offered by the CBOE. Let’s now see if the scenario is different for WTI Crude Oil futures:

The chart displays a significant negative correlation and all the “safe havens” seem to be very good when hedging crude oil positions, although, in 2012 there is a considerable positive relationship with Gold futures (we will explain why later). Specifically, Japanese Yen futures and the VIX Index both show a negative relationship which was evidently much stronger in 2011 than it is now and the analysis manifestly highlights that the best products to use, when hedging any crude oil position, are definitely Treasury Bond and German Bund futures because the negative coefficients that they display are very solid and the inverse rapport seems to be quite stable over time.

So, why are Gold futures a sub-optimal choice? There are no definite answers to that but there are two contributing factors which could help to explain what is happening:

1) The CME increased margin calls for gold futures in August 2011, hence, many traders could not afford to keep their positions open anymore and had to cut them. This resulted in a large drop in gold prices, even if investors were heavily using them to hedge against the massive plunge that risky assets experienced over the summer of 2011, and by looking at the above reported chart it is easy to notice that in 2011 Gold futures were the worst performers (the correlation is still negative but it is definitely weaker than the one registered for the remaining “safe havens”)

2) Gold prices are still used for hedging purposes; the only problem is that they are now employed to counterbalance a different type of risk: over-inflation. In particular, gold futures are being purchased to cope with a higher inflation that can be caused by the “expansive monetary policies” recently adopted by the Fed and the ECB (the Fed will purchase 40 billion dollars worth of mortgage backed securities on a monthly basis and the ECB just launched an apparently unlimited bond buying programme). This explains the uptrend in gold prices and the positive correlation with the so-called risky assets in 2012

According to our findings the best markets to use when hedging positions on E-Mini S&P500 futures are the VIX Index, Treasury Bond and Japanese Yen futures whilst Crude Oil futures are best covered by Treasury Bond and German Bund futures with the Asian currency and the VIX being the 3rd best option (they are equally good so we can both place them at the 3rd place in our ranking).

Conversely, Gold prices proved to be the worst performer and the least reliable market, amongst all the “safe havens” analysed in the present research, when trying to minimise the downside risk on equity indices and risky assets.


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E-Mini S&P500 Futures Volatility Forecast (05/10/2011)

E-Mini S&P500 futures opened at 1,158 on Monday, achieved 1,170 on Tuesday, plummeted to 1,149 on Wednesday, and rose to 1,157 on Thursday but on Friday the price dropped to 1,122 in the last minutes of the trading session.

The current volatility is 2% (31.7% annualised) and the plot is still showing a volatility curve which is trading at very high levels but now moving laterally with a shy downward sloping tendency.

The conditional variance is indeed very high but it is likely that the mean reverting process will start to become more and more “heavy” meaning that the volatility curve will probably tend to mean revert towards the next hours even if it will be unlikely to see a full and complete return to the long term equilibrium point.

The HyperVolatility team is bullish E-Mini S&P500 futures because the softening of the oscillation rate should support the price action which could potentially achieve the 1,180 – 1,200 area by Friday.

Nevertheless, unexpected bad news could drag futures prices back down and this time, should this happen, a retesting of the 1,000 support would be almost inevitable.

E-Mini S&P500 Futures Volatility Forecast (27/09/2011)

E-Mini S&P500 futures opened at 1,197 on Monday, touched 1,195 on Tuesday, dropped to 1,156 on Wednesday, plunged to 1,124 on Thursday and closed at 1,130 on Friday.

The actual volatility is 2% (31.7% annualised) and the TGARCH plot is manifestly showing an upward sloping curve which is just the natural consequence of the sharp drop futures prices experienced the last week. However, the curve is not extremely steep, although pretty high, implying that the upside potential of the conditional variance could be limited.

The European sovereign debt crises is still the main issue causing sleepless nights to investors and traders but the intention expressed by EU policymakers to bail out European banks, extend the peripheral bond buying programme and increase the EFSF will probably cool down investors’ nervousness.

The HyperVolatility team is bullish E-Mini S&P500 futures because the volatility should keep mean reverting over the next trading hours whilst the price action is likely to retest the 1,250 – 1,260 area by Friday.

E-Mini S&P500 Futures Volatility Forecast (19/09/2011)

E-Mini S&P500 futures opened at 1,163 on Monday, rose to 1,171 on Tuesday, jumped to 1,187 on Wednesday, achieved 1,211 on Thursday and closed at 1,214 on Friday.

The actual volatility is 1.4% (22.2% annualised), which is still a fairly high value if we consider an average fluctuations rate of 0.7% – 0.8% (11.1% -12.6% in annual terms), but the slope of the curve is now clearly downward sloping. Hence, the upcoming days should see an ulterior flattening of the conditional variance which, ceteris paribus, should complete the mean reverting process and settle around the abovementioned average values.

The current week does not present much macro-economic news coming from the States, apart from the FOMC announcement, and as a consequence most of investors’ eyes will focus on the European sovereign debt crises.

The HyperVolatility team is moderately bullish E-Mini S&P500 futures because, should the volatility keep in its downward trend, the price could touch the 1,230 – 1,240 by Friday.

The market remains highly unstable and any bad news coming from European politicians is going to provoke a short term sell-off which would completely twist our analysis.

E-Mini S&P500 Futures Volatility Forecast (06/09/2011)

E-Mini S&P500 futures opened at 1,208 on Monday, tested the 1,204 level on Tuesday, achieved 1,219 on Wednesday, plunged to 1,201 on Thursday and closed at 1,169 on Friday.

The actual volatility is 1.52% (24.1% annualised) and the TGARCH plot is evidently displaying an upward sloping curve which seems suggesting that an ulterior augment in the oscillation rate should be expected over the next trading days. Obviously, last Friday’s market drop considerably influenced the fluctuations rate but it is worth pointing out that the mean reverting speed started to decrease well before Friday. Should the market keep plummeting we could see readings around the 2.5% (39.6% in annual terms) by Friday again.

The HyperVolatility team is bearish E-Mini S&P500 futures because the expected increase in the conditional variance is going to drag the price action back down into the 1,110 area by Friday.

It is worth pointing out that the situation could completely change should Obama or Bernanke announce a new fiscal/monetary stimulus package because many investors who got burnt after the August sell-off would probably get back to buy equities or increase their exposure to risky markets.

E-Mini S&P500 Futures Volatility Forecast (30/08/2011)

E-Mini S&P500 futures opened at 1,124 on Monday, rose to 1,158 on Tuesday, achieved 1,171 on Wednesday, plummeted to 1,157 on Thursday and closed at 1,175 on Friday.

The current volatility is 2.2% (34.9% in annual terms) and the TGARCH plot displays a sideways movement of the volatility curve which clearly implies the fact that many traders and investors have been waiting for Bernanke’s speech. The conditional variance is still extremely high and the mean reverting process should manifest itself over the next trading hours although some short term volatility increases are quite likely to occur.

However, it is important to point out that the overall interpretation of the chart highlights that a softening of the market fluctuations rate is quite likely to happen.

The HyperVolatility team is bullish E-Mini S&P500 futures because the decrease in market volatility should favour a recovery of the price which could eventually retest the 1,230 points by Friday.

It is worth noting that the majority of investors and traders will focus on the macroeconomics news such as manufacturing index, NFP and initial jobless claims and therefore a great deal of attention will be needed during their announcement.

E-Mini S&P500 Futures Volatility Forecast (22/08/2011)

The market headed north in the first half of the week, meeting our last week’s expectations, but the disappointing figures related to the US manufacturing industry and the medieval approach to economics that some European politicians have, certainly helped to destroy investors’ confidence even further.

E-Mini S&P500 futures opened at 1,196 on Monday, dropped to 1,192 on Tuesday, plummeted to 1,189 on Wednesday, plunged to 1,144 on Thursday and closed to 1,123 on Friday.

The current volatility is 2.6% (41.2% in annual terms) and the TGARCH plot is showing an insistently upward sloping curve which seems suggesting that the upcoming days will see an ulterior increase in the oscillation rate although the present readings are well higher than the equilibrium point and still dangerously close to what we saw in the 2008- 2009 crash.

The HyperVolatility team remains bearish E-Mini S&P500 futures because the conditional variance is still very high and the VIX Index is not showing any sign of rest. There will be some short term uptrend but the overall week should not see a robust recovery of the price because it will take some times for the market to attract some buyers.

We expect futures prices to plunge over the next trading days and eventually retest the 1,000 level by Friday. No long position should be entered during this week even if the market could potentially show some movement on the upside.

This week all eyes will be on Europe because quite a few macroeconomics data are going to be released but on Friday a great deal of attention will be needed since investors will switch the focus on Bernanke’s speech.

E-Mini S&P500 Futures Volatility Forecast (14/08/2011)

The HyperVolatility team was right once again and the profit targets we suggested the last week have been successfully hit by futures prices making our analysis, once again, accurate and profitable. In particular, E-Mini S&P500 futures opened at 1,111 on Monday, rose to 1,171 on Tuesday, dropped to 1,123 on Wednesday, rose to 1,168 on Thursday and closed at 1,177 on Friday.

The actual volatility is 3% (47.6% annualised) and the TGARCH plot is evidently showing a downward sloping curve whose mean reverting process seems to be on its way. The fluctuations rate should decrease over the next trading hours because the conditional variance will try to settle around the 1% threshold (15.8% in annual terms) even if a short term, although not violent, increases of volatility are very likely to occur along the way down.

It is worth noting that this week most of the macroeconomics news coming from the US has been encouraging: better than expected initial and continuing jobless claims, better than expected core sales and lower than expected Federal budget deficit.

The HyperVolatility is bullish E-Mini S&P500 futures because the plummeting volatility curve is a clear signal that the down movement is now over and that many investors and traders are now buying back the market.

Moreover, the positive macroeconomics news and the decrease in the fluctuations of the VIX are all factors that are pointing towards a recovery of the price action. E-Mini S&P500 futures should eventually touch 1,250 – 1,260 points by Friday, credit rating agencies permitting.

E-Mini S&P500 Futures Volatility Forecast (08/08/2011)

The American economy has been hit by very bad macroeconomics figures and the US debt ceiling problems accentuated traders ‘concerns dragging the index down. Specifically, E-Mini S&P500 futures opened at 1,279 on Monday, dropped to 1,247 on Tuesday, rose to 1,254 on Wednesday, plummeted to 1,199 on Thursday and closed at 1,197 on Friday.

The volatility is now 1.78% (28.2% annualised) and the TGARCH plot is undoubtedly upward sloping implying that the big drop is far from being over. Particularly, the volatility does not show any retracement and its explosion was as rapid as “clean” (with no short term fluctuations of the curve) and consequently it is very probable that the conditional variance will keep augmenting over the next hours.

The US debt concerns, the S&P downgrading of US sovereign debt, the bad macroeconomics data about the manufacturing industry, the concerns about a potential default of big European countries have completely knocked down investors’ confidence and the panic is the only thing left in the market.

Furthermore, the slightly better than expected news coming from the NFP did not really help market sentiment even if on Tuesday the FOMC will try to regain a bit of credibility.

The HyperVolatility team is extremely bearish on E-Mini S&P500 futures because the oscillation rate should increase even more over the next hours dragging the price back down in the 1,050 – 1,100 area by Friday.

Beware of market up movements because, with this volatility, they are more likely to be bull traps rather than a bargain opportunity.

E-Mini S&P500 Futures Volatility Forecast (02/08/2011)

E-Mini S&P500 futures opened at 1,333 on Monday, dropped to 1,326 on Tuesday, plummeted to 1,299 on Wednesday, settled at 1,297 on Thursday and closed at 1,292 on Friday.

The actual volatility is 1% (15.8% annualised) and the TGARCH plot is evidently displaying a volatility curve which has dropped significantly over the last two weeks but that sharply mean reverted and jumped back up again during the last 5 trading days. Furthermore, the conditional variance seems now “intentioned” to trade within the actual ranges even if the fair equilibrium point for this market is around the 0.65% – 0.73% threshold (10.3% – 11.5% annualised).

Many markets are now close to break through their 2 years highs and the 1,350 – 1,360 threshold is the E-Mini S&P500 futures obstacles that bulls will have to overcome if they want to see the market keeps rallying higher. Specifically, the price action attempted to surpass this level quite a few times in the past but it never successfully managed to remain above it for a time sufficient enough to boost investors’ confidence.

The HyperVolatility team is bullish E-Mini S&P500 futures because the volatility plot shows a fairly robust curve which should keep the weekly average price up. In particular, we expect the 1,330 – 1,335 area to be retested by Friday even if some short term explosions of the conditional variance could easily bring back down futures prices (particularly in the first half of the week).

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