13 Mar 2023

Eurex Exchange

After the trials of 2022, traders mull the changing face of volatility

Ahead of the Eurex Derivatives Forum in Frankfurt this month, Eurex is releasing a series of articles that highlight the major themes affecting derivatives markets. One of the biggest of these has been volatility. We discussed this topic with a group of experts who will be appearing at the conference.  

Volatility was a constant presence in markets last year, as all asset classes were hit by inflation concerns, rising interest rates and the war in Ukraine.

These underlying factors created unpredictable market conditions that hit many portfolios’ performances and demanded skill in finding good hedges.

In 2023, uncertainty has remained a major challenge for traders across asset classes. However, its drivers have shifted, with many market participants now needing to adapt their strategies. While inflation will remain a defining theme for markets, participants are divided on how the trend will play out.

“As we started the year, there was a majority view that inflation was coming under control, accompanied by an increasingly optimistic view on China and the rest of the world. We saw equities rally, particularly in Europe. As a result, equity volatility reset significantly lower with the VIX and VSTOXX trading below 20 for the majority of the year,” says Alex Chatfield, global equity volatility trader at Optiver, a market maker that specialises in listed options across asset classes.

“Other investors were more nervous that inflation would be stickier than previously thought and would necessitate much higher rates to be controlled,” adds Chatfield. “The market has shifted towards this view lately with the US terminal rate moving 50bps higher in the past month on the back of strong jobs data and hotter-than-anticipated inflation.”

“There is a lot of uncertainty on what the outcome of the fight against inflation will be, and US rates could end the year anywhere between 3% and 6% as a result, which means we face another year of significant volatility across asset classes.”

While most markets were hit by volatility and underperformance last year, the divergence of outlooks is feeding into asset classes — with an increasingly stark difference in the positioning in rates and equity markets. While curves have inverted in rates markets, equity indices have staged a recovery from the drawdowns of last year to boast relatively stable performances — suggesting one of the two markets is due to experience a correction in 2023.

Finding the right hedge and the return of simplicity

With inflation still very much present in the global economy, hedging is as important and as challenging as it was last year. Despite the difficulties of protecting against volatility in 2022, some investors did manage to structure sufficient protection into their portfolios.

“Most of the exposure in German multi-asset portfolios is in bonds, so if interest rates rise it hurts us,” says Daniel Kutschker, head of multi-asset at LBBW Asset Management.

"Last year we tried to identify the most optimal way to hedge the risk of inflation rising further and turned our focus to energy stocks. The link between energy prices and inflation is obvious and these companies benefit directly from higher prices. Investing in energy stocks enabled us to hedge part of our bond exposure through equities. At this time, calls on energy sector indices were quite cheap, but puts were still selling at an attractive premium. So we bought call spread collars on the Stoxx Europe 600 Oil & Gas Index.”

Going forward, investors face a renewed challenge in finding the smart hedges for the rest of this year. Yet while market conditions are uncertain, central banks’ monetary tightening and rate hikes are also offering easier opportunities for returns after a near decade of yield hunting.  

With returns on government and high-quality corporate bonds now offering attractive yields, investors have an opening to rebalance portfolios towards greater simplicity in both risk-return profile and hedging.

“Clients had previously searched for yield through alternative investments in less liquid sectors and some structured credit products, which meant more complexity in hedging and risks,” says Bernhard Brunner, partner at finccam.

“Now, with high quality corporate bonds’ current trading levels, many pension funds can get target returns a bit more simply. This is a good opportunity to restructure portfolios and it helps the asset managers who hedge the residual tail risk in their portfolio. It makes things more straightforward, which we may see more of going forward if the interest rate environment has truly changed.”

Regional divergence?

The gap between rates and equity markets may not be the only divergence in markets this year. While inflation concerns and central banks’ rate hiking were treated as a mostly global trend last year, 2023 could be when regional differences become clearer and create opportunities for portfolio diversification.

In Asia, the Bank of Japan was already an outlier in its monetary policy but new governor Kazuo Ueda, and the path that he takes on yield curve control, is still an unknown for market participants. The reopening of China’s economy, which has beaten expectations so far, is also hinting at a different path for the region.

“Last year, China and Asia decoupled a bit from the inflation theme, which was more persistent in the US and Europe. So the drivers of equity market volatility were different across regions,” says Florian Reibis, Head of Portfolio Management Structured Products at HSBC Asset Management Deutschland.

“There may be some opportunities out there in the volatility space in Asia, with short volatility strategies like autocallables, where issuance broke down last year. That may be why Asian volatility is more attractive to sell, although this has to be monitored closely – when market participants come back, opportunity wanes.”

Listed options rise

As volatility rose last year, so have trading volumes in listed options. A new phenomenon driving this trend has been the popularity of shorter-dated contracts, some with daily maturities. The emergence of these products is pushing market participants to consider the implications for the speed of market movements, but also the opportunities for harvesting premia and hedging.

It has also led to some concerns about the potential for market disruption from these new instruments. With volumes increasing, it is a development that market participants agree will require more focused research and analytics.

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