The European Union (EU) referendum vote tonight has created a series of unknowns for investors. The first unknown is whether or not the U.K. remains in the EU. Should the U.K. vote to leave the EU, investors will face a second set of unknowns as the economic, political, and social effects of a Brexit make both their short- and long-term impacts on financial markets.
Because of these unknowns, trading around a particular outcome for this binary event may not be everyone’s cup of tea (pardon the pun). Action in U.S. equities and rates markets has been relatively muted this month. However, we have seen levels of implied volatility – which drives the prices of options (i.e. protection) on these asset classes –increase sharply with the uncertainty for tonight’s outcome.
Volatility indices such as CBOE’s Volatility Index (VIX) and Merrill Lynch’s MOVE have suggested the market expects high volatility in the short-term for equities and rates. Both the VIX and the MOVE have made sharp moves higher recently, despite relatively small declines in the S&P 500 Index and U.S. interest rates. The VIX in particular had abnormally high gains on June 10 and June 13 of 16.3% and 23.1% respectively when the S&P 500 Index declined -0.9% and -0.8%. Normally, gains in the VIX of this size are associated with declines of over 2% in the S&P 500 Index. When the S&P declined -10.5% peak-to-trough in the first quarter of this year, the VIX gained 54.5% over the same period, indicating a more orderly sell-off in risk assets.
Leading up to the vote the past few weeks, we have seen strong demand for downside protection against lower equities and rates. Two measures of option market dynamics, skew – which measures the price of puts relative to calls – and term structure – which measures the price of options with longer expiries relative to shorter expiries – both experienced sharp movements recently that started when the “leave” vote began to rise in the polls two weeks ago. The changes in these dynamics coupled with the elevated levels of spot implied volatility have made puts on equities and calls on interest rates both appear to be trading rich.
The movements in European volatility markets have been even more pronounced. The spread between volatility on the EURO STOXX 50 (SX5E) Index and the S&P 500 is the highest it’s been since the financial crisis. The same is true on the rates side. Spreads between implied volatility for swaptions on 10 year rates in Europe and the U.S. are at all-time highs. Although the U.K.’s decision is a European event, we should expect the decision’s effects on European volatility markets to impact the U.S. similarly, though with lesser magnitude.
Key Takeaway:The first six weeks of this year saw large declines in equities and interest rates accompanied by moderate increases in implied volatility across asset classes. Today, as we are hours away from the U.K.’s decision, implied volatility remains high while equities are not far from all-time highs and rates have recovered from their mid-June lows. Investors looking for upside in a risk-on event should the U.K. vote to stay may want to short volatility versus being long equities or short rates. For those wanting downside protection in case of a Brexit, short equities and long rates may be the better hedge instead of options. For those preferring to deal in options but wanting to minimize the vega impact, call or put spreads should be considered.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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