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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