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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 info@hypervolatility.com 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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Japanese Yen Futures Volatility Forecast (27/09/2011)

Japanese Yen Futures opened at 130.4 on Monday and remained at the same level on Tuesday, moved to 130.5 on Wednesday, rose to 131.2 on Thursday and closed at 130.4 on Friday.

The actual volatility is 0.45% (7.1% annualised) and the TGARCH curve is clearly moving sideways. It would appear that market participants do not expect wild fluctuations in the price action, at least in the short term, although the fact that the conditional variance did not increase despite the consistent drop occurred on Friday is a bit of a warning signal.

Japanese yen futures decreased sharply on Friday even if the equity markets saw an heavy sell-off because the intervention of the central bank of Japan scared away many investors that are now looking for protection elsewhere.

The HyperVolatility team is neither bearish nor bullish. We think that there could be a very short term explosion of the volatility in the first 2 days of the week but the overall picture should remain almost unchanged with futures prices probably settling around the 130 – 130.5 area by Friday.

Japanese Yen Futures Volatility Forecast (19/09/2011)

Japanese Yen Futures opened at 129.1, rose on 130 on Tuesday, touched 130.45 on Wednesday, achieved 130.48 and closed at 130.1 on Friday.

The volatility is now 0.51% (8% annualised) and the TGARCH plot is showing a slightly upward sloping curve which seems to suggest that the upcoming trading hours will see an increase in the fluctuations rate which a consequent drop of the price action.

The concerns about Europe and the great uncertainty surrounding the destiny of Greece , which seems to be really on the brink of collapse, would probably push investors towards safe haven again, if they have ever left them at all, implying that the buying pressure could augment and lift Japanese Yen futures as well as the volatility curve.

The HyperVolatility team is bullish Japanese Yen futures because the symmetric effect between volatility and price action during turmoil is an indication that the buyers will probably get back into the game and purchase some more assets in order to diversify the risk of their portfolios. Hence, we believe that futures prices should increase and eventually retest the 132 threshold by Friday.

The FOMC statement on Wednesday could potentially change the picture should new monetary policies being released.

Japanese Yen Futures Volatility Forecast (06/09/2011)

Japanese Yen futures opened at 130.1 on Monday, rose to 130.4 on Tuesday, jumped to 130.5 on Wednesday, dropped to 130 on Thursday and closed at 130 on Friday.

The volatility is trading around the 0.5% area (7.9% annualised) and the TGARCH plot is now displaying a slightly upward sloping curve which seems to announce a short term increase in the conditional variance although the overall chart shows a fairly stable curve.

The Bank of Japan is still trying to force its currency down in order to counterbalance the massive buying pressure generated by the sell-off in equity markets and by the increased concerns regarding the sovereign debt problems in Europe.

The HyperVolatility team is bullish on Japanese Yen futures because the volatility chart does not seem to present any sign of sharp retracements. Additionally, it is important to point out that the explosion in volatility, at least in the last months, have been caused by an enormous buying pressure rather than a market drop because, as we all know, the Japanese currency is considered to be a safe haven by investors and traders. We are expecting futures prices to skyrocket and achieve the 132 – 133 area by Friday.

Japanese Yen Futures Volatility Forecast (30/08/2011)

Japanese Yen futures opened at 130.2 on Monday, rose to 130.5 on Tuesday, dropped to 129.9 on Wednesday, plummeted to 129 on Thursday and closed to 130.4 on Friday.

The current volatility is 0.52% (8.2% annualised) and the TGARCH plot is displaying an upward sloping curve which seems suggesting that the upcoming hours could see an increase in the market fluctuations rate. The chart clearly shows that the volatility plummeted, found stability around the 0.5% level (7.9% in annual terms) but never experienced any short term bursts. Consequently, the probability for the oscillation rate to augment are quite high and such a phenomenon could manifest itself in the next hours.

Japanese Yen futures are still trading in an unknown territory because the 130 threshold had never been violated over the last 2 years and the fact that the price action is now moving sideways but the volatility is at historically low levels is a very strong warning signal.

The HyperVolatility team is bearish Japanese Yen futures because the buying pressure should diminish over the next hours causing a rise in the conditional variance which will inevitably drag the price back down in the 127 – 127.5 area by Friday.

However, it is worth pointing out that this week the macroeconomics calendar is quite intense and therefore some worse-than-expected news in the fundamentals could easily “poison” futures prices which could achieve the 132-133 threshold before the end of the week.

Japanese Yen Futures Volatility Forecast (22/08/2011)

The last week we were expecting a retracement of the market which would have been favoured by a softening of the panic among investors but the bad figures regarding the manufacturing industry in US and irresponsible politicians poured fuel on flames. In fact, Japanese Yen futures opened at 130.1 on Monday, rose to 130.3 on Tuesday, jumped to 130.7 on Wednesday, retraced at 130.6 on Thursday and closed at 130.7 on Friday.

The current volatility is 0.52% (8.2% annualised) and the TGARCH curve is clearly displaying a curve which is now fluctuating within its equilibrium point. The plot is highlighting a low volatility environment which is probably going to last for another while because the Japanese currency is being bought by investors who consider it a safe haven type of asset class.

Many investors and traders kept buying Japanese Yen futures in order to diversify their portfolios and run away from risky markets but it is worth noting that the Bank of Japan keeps trying to devaluate its currency and the current price action is clearly in an overbought zone with the volatility just ready to explode on the upside and drag futures prices back down again.

The HyperVolatility team is neither bullish nor bearish on this market because a lot of things will depend upon macro-events:

1)    An ulterior sell off will cause the volatility to remain where it is whilst the price action could hit the 131 – 131.5 area by Friday.

2)    Should things get back to normal in the equity world, Japanese Yen futures volatility would literally explode and the price would be inevitably pushed back down in the 128 area by Friday.

This week we decided to opt for a double scenario type of forecast because of the massive uncertainty amongst investors but we certainly reckon that the conditional variance is way too low to remain unaltered for an extended period of time.

Japanese Yen Futures Volatility Forecast (14/08/2011)

The Japanese currency was expected to break through the 130 level on the futures market and effectively so it was even if the 131 resistance was not achieved and the market settled just behind the 130.3 points. In particular, Japanese Yen futures opened at 128.9 on Monday, rose to 130 on Tuesday and moved sideways since then because 130.26, 130.2 and 130.23 have been the closing prices on Wednesday, Thursday and Friday respectively.

The actual volatility is 0.58% (9.2% annualised) and the TGARCH plot is visibly showing a downward sloping curve which has effectively touched its long term equilibrium point; that is 0.52% – 0.53% (8.2% – 8.4% in annual terms).

The Bank of Japan’s big sell-off did not manage to prevent its currency from appreciating, phenomenon that for a country which bases most of its revenues on exports could lead to financial catastrophe, but at least it decreased its growth rate.

Furthermore, most of the panic that we have been seeing in the market is now slowly dissipating and the fact that the volatility dropped significantly is a signal that the situation is about to change.

The HyperVolatility team is bearish Japanese Yen futures because the volatility should augment, at least in the short term, whilst the price should get back to normal and eventually touch the 126.5 level by Friday.

Nevertheless, ulterior bad macroeconomics news could alter and distort the price action once again by pushing Japanese Yen futures above the 131.5 threshold.

Japanese Yen Futures Volatility Forecast (08/08/2011)

The sharp drop that equity markets experienced over the last 10 days forced many investors to buy Japanese Yen futures which opened at 129.5 on Monday, rose to 129.8 on Tuesday, remained at this level on Wednesday, dropped to 126.5 on Thursday and closed at 127.6 on Friday.

The current volatility is 0.68% (10.7% in annual terms) and the TGARCH plot is clearly displaying an upward sloping curve which seems to suggest that an ulterior increase in the conditional variance should be expected in the upcoming trading days.

The Bank of Japan intervened, by selling something like 4 trillion yen, in order to prevent its currency from appreciating too much and this caused the heavy drop we all saw on Thursday. In particular, many investors got scared about a default of US and tried to diversify their exposure to market risk by investing in safe havens which is precisely why we had a violent appreciation of the Japanese currency against the dollar.

The HyperVolatility team is bullish Japanese Yen futures because the US debt downgrading, the European debt concerns and the slow growth in the global economy will “motivate” many investors to keep their money in “safe assets”. Particularly, the volatility should start softening over the next trading days whilst the buy pressure should augment despite the desperate intervention of the Bank of Japan to prevent its national currency from a further sharp appreciation which would heavily affect their economy given the fact that Japan is primarily an exporting country.

Japanese Yen futures should retest the 130 level and eventually break through it by Friday. The price action could even touch 131 should the global economy provide ulterior signs of weakness.

Japanese Yen Futures Volatility Forecast (02/08/2011)

The Japanese Yen opened at 127.7 on Monday, touched 128.3 on Tuesday, settled around 128.2 on Wednesday, moved to 128.6 on Thursday and closed at 130.1 on Friday.

The actual volatility is 0.52% (8.2% annualised) and the TGARCH plot is clearly displaying a fairly calm volatility curve, with some very short term augments of the conditional variance, which is now trading within its equilibrium level which is set at 0.5% (7.9% in annual terms).

Furthermore, the price is now trading very closely to the 130 resistance point but, as we anticipated the last week, this is an unknown territory because Japanese Yen futures never managed to break through this price in the last 2 years.

The Japanese Yen futures market has been used by many investors to diversify their portfolio risk whilst earning some small but constant returns in the long term and that’s why we witnessed to a quite steady uptrend over the last 3-4 months. The big question is: is this trend going to last forever?

The HyperVolatility team is bearish Japanese Yen futures because the extremely low volatility environment, which should explode in the short term, and the closeness to a key resistance point are factors that will push the price down back in the 126.8 – 127 area by Friday.

Japanese Yen Futures Volatility Forecast (24/07/2011)

Japanese Yen futures rallied sharply over the last 5 trading days because the market opened at 126.5 on Monday, dropped to 126.2 on Tuesday, jumped to 127.01 on Wednesday, settled at 127.5 on Thursday and closed at 127.4 on Friday.

The volatility is now 0.55% (8.7% annualised) and the TGARCH plot is displaying a fairly stable volatility curve which, although sensibly upward sloping, seems suggesting that the upcoming hours will see a moderate rate of market fluctuations.

On the other hand, it is worth pointing out that the price has now achieved the 127.4 level which has been touched only once in the last 2 years. Precisely, this strong resistance point was tested by investors soon after that terrible earthquake hit Japan and, although the “fundamental reason” was very strong, the price action got pushed back by central banks which wanted to prevent an excess of speculation.

The actual threshold will be very hard to break and, although the Japanese Yen keeps appreciating against the US dollar, it is likely that the price will fluctuate just below the 127.4 line in order to test market’s sentiment once again.

The volatility should remain low because the sideways movement of futures prices should keep the oscillation rate in the actual area but in the second half of the week there could be some short term explosions of the conditional variance which could possibly drag the price down.

The HyperVolatility team is bearish Japanese Yen futures, even if we expect a lateral movement of the price in the first 2 days of the next week, because the short term augment of volatility is likely to bring futures prices back down in the 125.5 – 126 area by the next Friday.

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