Long-term volatility levels are overstated

Volatility in the equity markets has shown no signs of abating in 2009, leaving investors wondering how much longer the rollercoaster ride will continue. Altaf Kassam, head of Asian equity derivatives strategy at Deutsche Bank, shares his views on what to expect in the year ahead and what this means for investors in Asia. 

It's a new year, but equity markets don't seem to have taken much notice. Where do you see equity volatility heading in the next 12 months?
The deteriorating global macroeconomic environment has ensured a choppy start to the year for equity markets and given the consensus for weaker numbers, earnings expectations may continue to soften. Mixed in with this of course are glimmers of hope: the market's reaction to rumours of further economic stimulus in China showed investors are ready and willing to react to positive news, even if the outcome was not as expected. This push-pull effect of optimism and pessimism will help to keep market volatility elevated.

We also think liquidity, or more precisely a lack of it, is a key factor driving volatility at present. As retail investors sit on the sidelines and institutions and hedge funds remain risk averse, the absence of a large bid in equity markets has caused spreads to widen and put a floor under volatility. We think this will continue to be the case in the short term as the economic outlook remains opaque.

Having said that, we believe the long-term levels of volatility implied by the market are overstated. If we look at major global indices, implied volatility is suggesting daily movements of more than 2% two-thirds of the time for the next 10 years. We think this scenario of heightened volatility far into the future is unlikely.

So what advice are you giving your clients? 
There are some compelling trades we think investors can consider. Given that we view the levels of long-dated implied volatility as too high, investors could take the view that realised volatility will be much lower over the longer term. This can be expressed through a variance swap, which sees one side pay a fixed amount at maturity and the other side paying a variable rate based on the level of realised market volatility. Specifically, we think that forward starting variance swaps -- swaps that take effect at a future point in time -- are the best choice for this trade as they avoid any marked-to market losses should short-term volatility remain high in the meantime, as we expect it will.

We also think correlation between global equity indices will begin to break down as the year progresses. Correlation is high at present as markets have tended to fall in tandem. However, given the varied response to the current financial crisis we expect countries to begin exiting the recession at different times and at varying pace. This could see performance of indices diverge, allowing investors to potentially generate returns by positioning one index against another.

A popular strategy from 2008 that we expect will remain relevant is selling out-of-the-money call options on select long stock positions. Japanese equity holders managed to generate returns of between 2%-6% by receiving premiums on the call options they sold last year. The main risk however is correlation -- specifically, that equity markets will rise in tandem. As such, we think writing short-dated calls is most appropriate. 

Asian convertible bonds also look interesting. Since last year convertible bonds have been sold down heavily by hedge funds, which accounted for around 75% of turnover in this market. The sell-off was largely due to the fact that hedging the credit or equity components of these bonds became difficult after short-selling restrictions in equity markets came into effect and liquidity in credit default swaps became constrained. We subsequently think certain names have been oversold and currently look attractive. These bonds can be viewed either as yield plays or as cheap call options in our view and given that maturities average around three to five years from now, the potential for a price recovery is something to consider.

Volatility has played havoc with investors' ability to hedge over the past 12 months. Will the situation improve?
Since the August 2007 correction, option premiums have continued to rise to the point where hedging through vanilla put options has become prohibitively expensive for some investors. We believe this is likely to continue being the case as volatility remains elevated in the short-term.

We therefore suggest investors look at a term we call skew to guide their hedging strategies. Simply put, skew gives investors an indication towards market sentiment and is based on activity in equity options. If there is a heavy bias towards buying call options for example, upside skew will be positive, indicating higher market returns. If downside skew is positive, then the market may expect prices to fall, which will be reflected in demand or a higher premium for put options. 

Not surprisingly, downside skew is steeply positive in Asian equity markets at present. As such, premiums on put options are high and do not provide a very cost-effective way to hedge. In Asian equity markets, one means of reducing this cost is via a put spread. This simply involves an investor buying a put at the level they want and then selling a put at a level they think the underlying is unlikely to reach. The premium earned on the put sold is then used to offset the cost of the put the investor has bought. The risk to this strategy of course is that markets fall further than expected.

Our team provides regular updates on the prices of various hedging strategies on major Asian exchanges. Currently, our data shows certain short-dated put spreads to be the most cost-effective means for hedging downside risk in Asian equity markets.

What has been the impact on investors in terms of how they approach the market?
We think volatility will continue to be a determining factor in how investors access equity markets. Greater value is being placed on liquidity, with highly structured instruments falling out of favour compared to more vanilla products, such as equity options, futures, swaps and index products. Compounding this are industry-wide concerns over counterparty risk, with listed products being preferred to over-the-counter derivatives. 

Banks are therefore increasingly focused on ensuring investors have access to as broad a range of vanilla or lightly structured equity derivative products as possible. We expect this trend to remain firmly in place in 2009 and are working hard to structure ideas around this.

Are there specific dynamics that drive volatility in Asian equity markets?
Liquidity in Asian equity markets has been an amazing success story. Despite pulling back from its highs, liquidity has more than kept pace with growth in market capitalisation, both in terms of cash and equity derivatives.

A primary driver for this has been a strong retail bid, which was largely responsible for the record highs we saw for the Hang Seng Index in October 2007. While this has obviously subsided given current market conditions and the fall in structured equity product issuance, retail investors remain a force in Asian equity markets. Volumes in the Hong Kong warrants market illustrate this point, with turnover reaching 40% of the total value traded on the exchange in January 2008. That figure has subsequently dropped to 5%, but gives an example of the potential liquidity the retail sector can inject into Asian markets. When markets begin to recover, retail inflows could be a strong supporter of upside volatility.