After publishing an initial article in March 2022, we return in this article to update the cover premiums at the end of May 2022.
By Alexandre Ryo, Head of Development, Overlay & Customized Portfolio Solutions business
We focus here on optional bonuses according to three different visions:
- ” Protection of long flights »: characterized by a coverage option -5%/-20% 1 year
- ” Tail risk hedging » : characterized by a 1-year coverage option of -20%
- ” scattering »: Focus on stocks or sectors with high diversification within the markets
Protection of long flights
If we focus on long vol hedging premiums we currently have a level of 0.7% in Europe and 0.9% in the US. These hedging premiums are currently 3.3% on the Swiss SMI index, 3.8% on the European Eurostoxx 50 index and 4% on the American S&P500 index.
The increase in these option premiums, synonymous with investors’ expectation of increased volatility, which began in the summer of 2021, is now reaching levels similar to 2018 (FED tapering), 2015 (China recession) or quite close to 2011 (European peripheral crisis ).
The big winner is the American market, which after hitting a low in late 2017 has almost doubled at 2.2% hedging premium and is back to levels not seen since 2010/2011 (excluding Covid stress). . Conversely, the Swiss market remains more subdued with a level below 2015 and far from 2010/2011 (-1%). However, the markets are still a long way from a strong volatility stress similar to 2008, so the option premiums are likely to increase again by almost 50%.
Tail risk hedging
If we now focus on the tail risk hedging premia, we currently have levels with very different increases: the Swiss market only increases from 0.4% to 2% premium; the US market increases from 0.7% to 3.8% premium; and the European market increases from 1% to 3.5% premium.
We can therefore estimate that the “black swan” risk is now more likely to be expected in Europe than in other geographic areas, which the war in Ukraine provides as an explanation. Generally, even if levels rise, as we see graphically here, we remain at historically low levels. In fact, we are a far cry from the severe exposure to extreme risk that we experienced during the 2020 pandemic, in 2011, or even during the 2008 GFC. The most striking remains the Swiss market, for which the increase in the Tail Risk premium is only epsilonesk compared to the level we have experienced historically, 3/4x higher.
So in comparison, what we see here is that between the Long Vol hedging premium and the Tail Risk premium, the investor’s vision is much more focused on a sustained increase in volatility, rather than an extreme risk for the markets and a global one Deleveraging similar to what we saw during previous major crises (2020, 2008 or 2001). The risk of a global capitulation therefore seems weakly anticipated at the moment and can be explained by the wide dispersion that we will now analyze.
We have described it in our previous one article “What is important is not the downfall … it is the alternative”, a profitable strategy in 2022 remains the diversification of shares. The latter, as discussed above, can explain the lack of market capitalization in general. On closer inspection, however, the capitulation seems to be felt in either sectors, factors or specific securities.
We are analyzing something very simple here: comparison between the YTD performance of the Eurostoxx 50 (in orange) and the YTD performance of the 22 largest stocks that make up this index.
Even if the decline in the Eurostoxx remains moderate, this can be explained on closer inspection by a very wide spread. In the top 5 alone, two stocks are down more than 25% (ASML and LVMH) and two stocks are up 17% and 22%. Of these top 22, we have six trending stocks that are declining above the “bear market” (indicated by a -20% decline). Conversely, Bayer is unaware of the crisis and is reporting an increase of more than 36%. Growth and consumer stocks remain the hardest hit in 2022, stocks or stocks linked to commodities or those with low valuation are doing well.
Today, if we look at the expected volatility of these securities and compare them to the Eurostoxx 50, we have to pay a volatility of 28% for the basket of shares, while the volatility of the Eurostoxx 50 is expected to be 22% over 1 year. This gap seems small at the moment given the current moves, the realized volatility gap we have year-to-date (underlyings are 8.5% more volatile than the broad index), and the implied spread level, which appears historically low.
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Disclaimer for overlay solutions: its objective is to reduce the risks of a given portfolio without eliminating them completely and does not aim to offer any guarantee or protection of the portfolio, which therefore remains exposed to the risk of capital loss. In particular, this solution is also subject to a model risk linked to the implementation of the main objective of risk reduction, based on a systematic principle. There is a risk that this model is not efficient. Finally, this solution introduces risks linked to the use of financial futures instruments, in addition to the specific risks linked to the existing portfolio, as well as an operational risk. Due to the existence of hedging, the potential return could be lower due to the impact of hedging costs and the fact that the portfolio could only partially participate in the upside should the market rally.
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