Emerging Market Bonds During A Financial Crisis: As Expected Not a Safe Haven

I wrote on May 4 that I didnt find the case for holding emerging makerts bonds very convincing and that they would likely suffer during the crisis emanating out of Europe.

Bloomberg reports that yield spread over treasuries are widely across the board in the fixed income markets and emerging market bonds are not immune:

Bond Sales Fall to Least in Decade, Yields Soar: Credit Markets

....In emerging markets, yield spreads narrowed 22 basis points to 317 basis points, the least since May 19, according to JPMorgan Chase & Co.’s Emerging Market Bond index. The spread has widened from this year’s low of 230 on April 15.

"Common Sense" from James Stewart on Options..Not Exactly Sensible

James Stewart's Common Sense investing column in the WSJ is like a slow motion, low decibel version of Cramer's mad money. He throws out a group of buys and sells and never presents a scorecard of how his proposed trades do, except to mention some winners. But even the with the "winners" he never specifies dates and prices for his proposed portfolio changes.

As if that were not bad enough he often presents illogical rationale for his trades (again without details). In today's column we find the following about his stock option activity:

. I bought long-term Apple call options at only a modest premium to the current price,

the above is so vague as to be meaningless

and  he writes

I also raised some cash by selling some Google put options. This is the first time I've sold puts in over a year. (Selling puts means you agree to buy shares at the strike price if they're trading below that price when they expire.) It's a strategy I recommend when option prices are high,

Now anyone knowledgeable about options knows that "cheap" or "expensive"  is only relevant in terms of the implied volatility of the options.

Stewart didnt give details of his trades (of course) but

the January 2011 apple options are trading at an implied volatility of close to 42.

The short term june 2010 google options have a volatility of 34%

So it would seem to me (and most options traders) that at first glance it seems Mr. Stewart bought the expensive options and sold the cheap ones.

In any case given that both goog and aapl have heavy weights in the nasdaq it seems highly unlikely that the options on aapl would be cheap at the same time google option prices are "high"



The implied volatility for the nasdaq (the nasdaq equivalent of the VIX) is the vxn. The volatility on the vxn is very close to that of apple and it is clearly at historically high levels. Where it will go from here is certainly an open question,

But one thing that is pretty sure to me:  the likelihood that options on apple "trade at a modest premium"  at the same time the prices on googl options are high under current market condiions is zero.

What Was That Famous Line From JP Morgan ?.....

When asked for his forecast for the stock prices his reply was "they will fluctuate".
Well I would add a bit to that forecast for the near future....they will fluctuate alot. Faced with this prospect and the ability for retail investors to buy volatility in one instrument (vxx and vzz) I would see that as a far more logical move than trying to pick bottoms or tops.Mr. Market is giving at this point that the beginning of summer will be quite interesting for investors.


From the WSJ:

The sudden downdraft in world markets demonstrates that, despite more than a year of stock recovery, investor confidence in the wake of the financial crisis remains uncommonly fragile.
Until a few weeks ago, the market seemed to be returning to a pre-crisis norm. Commonly watched gauges of investor anxiety had tumbled to levels seen before the crisis. Corporate profits and economic growth proved surprisingly resilient, quieting investor doubts about the rally's staying power.

But Europe's difficulties in resolving its debt problems, the "flash crash" of May 6 and the national debate over the proper role of the nation's top banks have again put investors on edge, reawakening the fear and anxiety of the financial crisis that were lurking just below the surface. The sudden surge in gauges like the Chicago Board Options Exchange's volatility index, a commonly used barometer of investor anxiety, and the sharp correction of major stock indexes showed just how nervous investors are.
That suggests that more volatility is in store and future stock gains could be harder to come by.

T

Another strong sign of investor anxiety lately is their return to options to hedge risk. In times of increased fear, investors buy put options, permitting them to sell shares at a prearranged price, which helps protect them from losses in the event that prices suddenly fall.
The CBOE's volatility index, or VIX, is a measure of options demand. On April 20, with stocks and investor confidence rising, the VIX finished the day at 15.73, down where it was before the 2008 financial crisis began in earnest.

The Big Guys Are Still Fighting The Fiduciary Standard

I have written several times about the prospect of including the fiduciary standard as a standard for stockbrokers and insurance agents. Despite the senate passing the new law on financial services regulation the issue is still open as the House and Senate versions treat the issue differently. Kathy Kristof of the la times writes:

Two similar versions of financial reform — the one approved by the Senate on Thursday and the one passed by the House in December — must now be reconciled to create a final law.  ...

Now there's a last-ditch battle to determine whether the reform package ultimately will require all financial advisors to be fiduciaries, or trustees for their clients, as the House bill requires.....

When the Senate voted to cut off debate on financial reform Thursday, tough language demanding that all advisors be held to a high standard of trust was sidelined for a provision that would just have securities regulators "study" the issue. That would leave brokers and insurance agents able to continue with business as usual. 

Most individuals aren't aware of this issue and dont realize that registered investment advisors (like me) are held to fiduciary standards brokers and insurance agents aren't. As the same article notes;

This fiduciary provision is simple, says Bob Webster, a spokesman for the North American Securities Administrators Assn. It demands that financial advisors — regardless of whether they call themselves "wealth planners" or "investment specialists" — put their clients' interests ahead of their own.
If they have a conflict of interest, they have to disclose it. If they think an investment you own or a product they're selling isn't good for you, they have to say so.
You thought that was already true? Think again,.....

Kristof goes through a few myths used by the industry against the fiduciary standards and debunks them. Here's one

Myth: Imposing a fiduciary standard on all financial advisors would deny investors access to valued products and services.
Reality: Investment professionals could sell exactly the same products they sell now, but they would not be able to tell you that they were offering impartial advice when they were simply trying to sell a product that would earn them a commission......

Brokers and insurance agents take great pains to obscure the difference between advisors who must look out for your best interests and those who don't have to. That leaves investors learning the lesson of who they can trust too late — when they're already stuck with a high-cost, low-value product that enriched the advisor rather than the investor. It's time to stop calling salesmen advisors.

Why Does The Story Always Seem The Same ? (Hedge Funds Division)

I cannot count the number of times I have read about advisors who recommend the use of hedge funds in a portfolio because they are "uncorrelated" with the overall market and "because of their ability to go short can make money in a down market".

But it seems like the story is always like this one (below). With a few exceptions of course the overwhelming evidence is that hedge funds are highly correlated to overall market trends. In fact it seems that their years of outperformance vs the market are in years when the market goes up and vice versa. And that shouldnt really be surprising the funds specialize in taking higher risks than the market through leverage and concentrated bets on the riskiest parts of the market. Thus when the market hits a speed bump their positions get  hit hard.

Three clear conclusions:

1. Hedge funds are not an asset class they are a bet on an individual manager's ability to generate alpha

2. True alpha= excess returns on a risk adjusted basis is very very hard to generate on a consistent basis. Those hedgies that generate excess returns are largely not generating alpha they are taking additional risk relative to the market with leverage and concentrations in higly volatile sectors. Add in the lack of liquidity vs investments like listed etfs and the case for hedge funds diminishes future. A true evaluation must adjusted for both risk and lower liquidity.

3. Just when an investor needs diversification most....during market crises hedge funds provide little of it.


from the FT:

Hedge funds hit by May volatility

By Sam Jones, Hedge Funds Correspondent
Published: May 17 2010 03:00 | Last updated: May 17 2010 03:00

Some of the world's biggest hedge funds have suffered significant losses this month after high levels of volatility across markets and the shortlived stock market plunge in New York combined to wipe billions from portfolios.
Losses in the first week of May alone erased all gains made so far this year for some managers, according to investors who spoke to the Financial Times.
Large losses in a single week are not unusual for hedge funds, which typically aim to outperform markets and cut volatility, but those this month have come as a stark reminder to many of the continuing uncertainty over the economic recovery.

Now That We Understand A Bit More About VIX, VIX Futures VXX and VXZ (from the last post) How Best to Use VXX and VXN

Whar are the implications for the market outlook of the analysis in the previous blog for the "real world" of the markets:

It seems the market anticipates near term volatility no doubt on the downside in particular.

As for those watching the vix, vxx and vxz:

The period since the introduction of the vxx have no doubt been extremely painful and frustrating for those that held it. Since the vxx represents the near term future and the contango was very large the vxx suffered large losses due to the cost of rolling futures contracts as they expired. Hence the sharp decline in the vxx far more extreme than the cash index. As for the vxz the losses were less extreme becuase of the less extreme curve between the mid date futures it represents and the less frequent roll trades.

But judging by much analysis I can have seen people have thrown in the towel on the vxx based on the short time period since the instrument has started trading. As seen in the table above as the vix increases to extreme levels the curve of term strucutre fkips, In other words the holder of the vix gets an extra boost in return just when he wants the hedge to be most effective.

Effectively the time decay of option premia hurt the vxx far more than the vxz. And the vxx is more sensitive to changes in the vix than is the vxz.

This differential means that the vxx is far more sensitive to changes in the vix than the vxz. The "hedge ratio" ration of price change in the etn relative to change in the far higher for vxx to vxz.

As volatility and the vix increased massively over recent trading days this was readily apparent the long suffering vxx holder saw their positions increase a multiple of the vxz and a large multiple of the actual volatility in the s+p 500 and by extension the global equity markets. Those looking for a 1:1 movement between the vix and one of the etns were disappointed but they were looking for the wrong result. The etns are linked to the future not to the vix which is an index and cannot be traded.

The correct way to look at these instruments is either as a hedge of a long equity position or a trade.  Since volatility is more extremen on the downside, the vxx or vxz position would offset those losses  And the instruments performed extremely well  the vxx for instance on friday moved  the percentage move in the sp 500, the vxz moved . Furthermore with the flip in the futures curve from contango to backwardazation the vxx will likely suffer little or no loss when rolling contracts/

So what is the bottom line for use of the vxx and vxz:

They should be viewed as a way to offset the actual volatility of the S+P 500 either as a trade or a hedge.

Traders should look to the vxx which has a higher leverage to the underlying moves but a slow market will translated to a far steeper decline in value. The volatility of volatiliy is far higher for the vxx. But the leverage of the vxx is quite large recently it moved 4-5x the move in the sp 500

Those looking for a longer term hedging vehicle should look to the vxz. Recently it moved around 2x the move in the sp 500.

Using the above numbers one could argue that a 20=25% position in vxx would offset all of the loss on a stock portfolio during turbulent times. For vxz it would be closer to 50%.

This instrument has an  added benefti. In a turbulent down market we have observed two things:

volatility spikes increasing the leverage of these instruments
Among equtiies diversification becomes weaker and "the only thing that goes up in a down market is correlation". So these instruments provide a hedge (although of course of not identical efficacy ) of the non US parts of an equity portfolio as well as the small cap US despite the fact the sp 500 is large cap US stocks


Here are 3 mos graphs of the vxx(top) and vxz note how painful the futures roll has been for longer term holders of the vxx while recently the market has been more favorable to vxx over vxz holders.

So what would be the optinal strategy for those that want to hold a black swan hedge in their portfolio ? A longer term position in the vxz an addition of vxx position or a partial swap from vxz to vxx in anticipation of higher volatility in the market and a reversal of the position during a time of market stability. Of course the likelihood of getting that timing right is as great as the likelihood of timing any other market. But a mix of a larger position in vxz combined with a smaller proportion of vxx probably the best approach with the caveat to avoid the vxx completely when the futures mkt is in deep contango.

The VIX Term Structure and What it Says About Future Volatilty...and That Black Swan Hedge

Judging by the CBOE website there is considerable interest in the term structure of vix futures measured as the difference between near term and further out futures on the vix and also the realtionship of futures to the cash vix. This can be a premium (contango) or discount backwardization, In fact there seems to be dispute even as to how to interpret that curve as the market predictor of future volatility.

A presentation on this subject on the cboe website they present a contrasting view of option expert and author Lawrence McMillan who sees an uupward sloping curve as a portent of high future volatility and that of "traders" who hold the opposite view. Based on my observation of market data, my experience in the currency options market and my inclination to follow the money rather than the analysis on paper I go with the view of the traders.

My reasoning is as follows. First off it is important to know that the vix itself is not a commodity that can be traded it is really what I would call a "plug number" or the calculated implied volatilty of the near dated S+P options. Without getting into a detailed explanation of the calculation (you can find that here) suffice it to say that if one knows the price of the option, the strike price of the option, the days to maturity and short term interest rates one can calculate the "implied volatility of options". Since professional market makers in options can (with limitations change the directional exposure of any option through reversals and conversions they are trading implied volatility).

The enemy of an option holdesr is a dead market. If the market is devoid of volatility, the option holder's positions will not  increase in value and the time decay of the options will be a slow bleed. Conversely the trader holding a short option position makes a bit of profit each day through time decay  in a dead market. Add to this the lack of  demand from directional option players in a dead market.  Since the time decay of short dated options is higher than that of long dated options the selling is more pronounced in the short dated options this is reflected in the vix and in the short dated futures hence contango  (short dated futures at a discount to longer dated).

When the market heats up two things happern those with short options scramble to reduce their risk of their short options moving into the money.  If the expectation is for a short term boost in volatility the first move is to buy the cheapest options  that are most sensitive to movements of the underlying (pushing the vix, a calculated number based on near term options) and to push near term futures at a premium to the longer term futures =  backwardization in the futures.

The cboe has some data on the curve  based on the differential between the cash vix and the futures, the direction of that differential is usually the same as the shape futures curve as well as the spx itself. Sharp downmoves in the lead to the vix trading at a premium to the futures (and generally the futures curve going into backwardation. The chart of the fall 2008 market collapse period can be compared to the middle of 2009 and the mkt recovery. And since extremes of volatility coincide with sharp market declines it is not surprising to see the pattern in this chart from fall of 2008 of vix cash vx futures.


The cboe website also has data for  for the relationship between the cash vix the futures and the futures curve . Here is a great table. The higher the vix the deeper the backwardation and vice verssa. Not surprisingly traders play this spread buying the near date and selling the further date in anticipation of high volatility and reversing the position when the outlook changes.

Average Realized VIX Spreads 1990-2003

Spot VIX	Spot to 1 Month	1 to 2 months	2 to 3 months
15 to 20	4.02	1.64	1.74
20 to 25	0.92	0.85	0.25
25 to 30	-0.96	-1.24	-0.48
30 to 35	-3.23	-2.88	-1.57
35 to 40	-4.63	-2.94	-2.77
40 to 45	-9.95	-4.11	-2.33

The pattern was born out in the recent market .Here are 1 to 2 month spreads around the flash crash date (below). The next post will comment on how to use this information in hedging and trading..

29-Apr	1.99
7-May	-6.05
14-May	0.71