Last year, in a post entitled Credit Derivatives-Is This Time Different we wrote about credit derivatives and their potential impact on the markets. Since then, they have started attracting more and more attention. For example, Bloomberg recently reported that collateralized loan obligations (CLO), a type of complex credit derivatives, are becoming a favorite financing vehicle for corporate America.

...Investors haven’t been able to get enough of the repackaged corporate loans known as collateralized loan obligations. That intense demand, is allowing the managers that put these securities together to sell off pieces of CLOs that by law they previously had to hang on to. These sales are the crest of what could be a $7 billion wave of such deals. Read more

As reported by the Washington Post, money raised from these CLOs is used to finance corporate stock buybacks and dividend payouts.

The most significant and troubling aspect of this buyback boom, however, is that despite record corporate profits and cash flow, at least a third of the shares are being repurchased with borrowed money, bringing the corporate debt to an all-time high, not only in an absolute sense but also in relation to profits, assets and the overall size of the economy.

In recent years, moreover, a greater part of corporate borrowing has come in the form of bank loans that are quickly packaged into securities known as CLOs, or collateralized loan obligations, which are sliced and diced and sold off to sophisticated investors just as home loans were during the mortgage bubble. Bloomberg News recently reported that pension funds and insurance companies, particularly those in Japan, can’t get enough of the CLOs because of the higher yields that they offer. Wells Fargo estimates that a record $150 billion will be issued this year, roughly double last year’s issuance. And as happened with the late-cycle home mortgages in 2007 and 2008, analysts are noticing a marked decline in the quality of loans in the CLO packages, with three-quarters of them now without the standard covenants designed to reduce the chance of default. Read more

But how risky are these collateralized loan obligations?

In the current market environment, it’s difficult to evaluate the riskiness of these CLOs. First of all, Value at Risk (VaR), a popular risk measure used by many financial institutions to quantify the risks and manage economic capital, has been developed and tested in a low-interest rate and low-volatility environment. This makes the VaR  vulnerable to future change in the market environment.

Second, in the calculation of VaR for a credit derivative portfolio, we would have to determine the probabilities of default (PD) and loss given default (LGD) of the borrowers. Both of these quantities are difficult to estimate. Furthermore, the correlation between PD and LGD is not constant and will likely increase during a market stress.

All of these factors make the VaR less accurate.  Consequently, managing the risks of a CLO portfolio is a non-trivial task. A slight change in the market environment can lead to damaging consequences.

Originally Published Here: Are Collateralized Loan Obligations the New Debt Bombs?

According to Marketwatch, Goldman Sachs strategists just issued a warning regarding the volatility index, VIX,

Goldman analysts Rocky Fishman and John Marshall said that the VIX, which uses options bets on the S&P 500 to reflect expected volatility over the coming 30 days, has been hovering at or below 13, marking its lowest level since around January (though it is tipping up in Monday trade). Its current level takes the gauge of implied volatility, which tends to rise when stocks fall and vice versa, well below its historic average at about 19.5 since the fear index ripped higher in February.

Goldman argues that the 5-day intraday swings of the S&P 500 have been out of whack with the price of the cost of a one-month straddle on the index. A straddle is an options bet that allows an investor to profit from a sharp move in an asset, but without wagering on the specific direction of that expected move. In other words, it is an inherent bet on volatility. A straddle can be structured by buying a put option, which confers the owner the right but not the obligation to sell an asset at a given time and price, and a call option, which offers the comparable right to buy an underlying asset, at the same expiration date and strike price. Read more

Volatility Index VIX as of May 18 2018

But is the volatility index predictable? How about VIX futures and ETFs?

A recent research article raised some interesting questions,

The VIX index is not traded on the spot market. Hence, in contrast to other futures markets, the VIX futures contract and spot index are not linked by a no-arbitrage condition. We examine (a) whether predictability in the VIX index carries over to the futures market, and (b) whether there is independent time series predictability in VIX futures prices.

The answer is no.

The answer to both questions is no. Samuelson (1965) was right: VIX futures prices properly anticipate predictability in volatility, and are themselves unpredictable. Read more

But then why do we trade VIX futures and ETFs?

We think that the reasons might be:

• Trading the spot VIX is difficult,
• When trading VIX futures and ETFs, we exchange the predictability of the spot index for a little extra return stemming from the volatility risk premium.

ByMarketNews

Published via http://harbourfronttechnologies.blogspot.com/

The overnight index swap (OIS) has come into the spotlight recently, due to the widening of the Libor-OIS spread. For example, the Economist recently reported:

WATCHING financial markets can be like watching a horror film. A character walks into the darkness alone. A floorboard creaks. The latest spooky sign is the spread between the three-month dollar London interbank offered rate (LIBOR) and the overnight index swap (OIS) rate. It usually hovers at around 0.1%, but has recently climbed to 0.6% (see chart). As it widens, bankers are bracing for a jump scare.

To see why, consider what each rate represents. LIBOR is the rate that banks charge other banks for unsecured loans. The OIS rate measures expectations for the federal funds rate, which is set by the central bank. As LIBOR rises above the OIS rate, that suggests banks fear it is getting riskier to lend to each other. (The gap was 3.65 percentage points in the depths of the crisis, after Lehman Brothers filed for bankruptcy.) Read more

[caption id="attachment_459" align="aligncenter" width="628"] Libor-OIS spread as at May 2, 2018. Source: Bloomberg[/caption]

What exactly is an overnight index swap?

An overnight index swap is a fixed/floating interest rate swap that involves the exchange of the overnight rate compounded over a specified term and a fixed rate. The floating leg of the swap is related to an index of an overnight reference rate, for example Canadian Overnight Repo Rate Average (CORRA) in Canada or Fed Funds rate in the US.

Usually, for swaps with maturities of 1 year or less there is only one payment. Beyond the tenor of 1 year, there are multiple payments at regular intervals. At the inception of the swap, the par swap rate makes the value of swap zero. That is, the net present value (NPV) of the fixed leg equals the NPV of the floating leg,

where N denotes the notional amount of the swap,

R_i-1,i is the forward OIS rate,

Z_i is the discount factor at time t_i

is the daily accrual factor, and

 s_K is the par swap rate of a swap with maturity t_K.

The OIS discount factors (DF) are often used to value interest rate derivatives that require a posting of collateral.  The OIS discount factor curve is built by bootstrapping from the short maturity and long maturity overnight index swap rates in order of increasing maturity.  The processes for backing out the discount factors from the short and long maturity swap rates are, however, different.

In the short end of the curve, given that there is only 1 payment, the discount factor is calculated based on the spot rates. At the long end of the curve, the DF curve is determined as follows,

• Payment dates are generated at each 6 months (or a year, depending on the currency) from the time zero up to 30 years,
• Par swap rates are determined at each payment date. To obtain the par swap rates for the payment dates where there are no swap quotes, one linearly interpolates the par swap rates in order to complete the long end of the swap curve,
• Using the par swap rates at each payment date, discount factors are obtained by solving a recursive equation.

This is just an introduction to OIS discounting. The process for building an OIS discount curve involves many technical details. We are happy to answer your questions.

Article Source Here: Overnight Index Swap Discounting

Published via http://harbourfronttechnologies.blogspot.com/

In a previous post, we showed that the spot volatility index, VIX, has a strong mean reverting tendency. In this follow-up installment we’re going to further investigate the mean reverting properties of the VIX. Our primary goal is to use this study in order to aid options traders in positioning and/or hedging their portfolios.

To do so, we first calculate the returns of the VIX index. We then determine the quantiles of the return distribution. The table below summarizes the results.

Quantile	50%	75%	85%	95%
Volatility spike	-0.31%	3.23%	5.68%	10.83%

We next calculate the returns of the VIX after a significant volatility spike. We choose round-number spikes of 3% and 6%, which roughly correspond to the 75% and 85% quantiles, respectively. Finally, we count the numbers of occurrences of negative VIX returns, i.e. instances where it decreases to below its initial value before the spike.

Tables below present the numbers of occurrences 1, 5, 10 and 20 days out. As in a previous study, we divide the volatility environment into 2 regimes: low (VIX<=20) and high (VIX>20). We used data from January 1990 to December 2017.

	VIX spike > 3%
Days out	All cases	VIX<=20	VIX>20
1	56.1%	54.9%	58.1%
5	59.7%	58.4%	61.8%
10	60.3%	57.0%	65.8%
20	61.6%	57.0%	69.5%

 

	VIX spike > 6%
Days out	All cases	VIX<=20	VIX>20
1	58.2%	56.9%	60.3%
5	62.5%	62.0%	63.3%
10	64.0%	61.7%	67.6%
20	65.9%	61.4%	73.2%

We observe the followings,

• The greater the spike, the stronger the mean reversion. For example, for all volatility regimes (“all cases”), 10 days after the initial spike of 3%, the VIX decreases 60% of the time, while after a 6% volatility spike it decreases 64% of the time,
• The mean reversion is stronger in the high volatility regime. For example, after a volatility spike of 3%, if the VIX was initially low (<20), then after 10 days it reverts 57% of the time, while if it was high (>20) it reverts 66% of the time,
• The longer the time frame (days out), the stronger the mean reversion.

The implication of this study is that

• After a volatility spike, the risk of a long volatility position, especially if VIX options are involved, increases. We would better off reducing our vega exposure or consider taking profits, at least partially,
• If we don’t have a position prior to a spike, we then can take advantage of its quick mean reversion by using bounded-risk options positions.

Learn More Here: VIX Mean Reversion After a Volatility Spike

Published via http://harbourfronttechnologies.blogspot.com/

In this post, we are going to examine a trading system with the goal of using it as a hedge for long equity exposure. To this end, we test a simple, short-only momentum system. The rules are as follows,

Short at the close when Close of today < lowest Close of the last 10 days

Cover at the close when Close of today > lowest Close of the last 10 days

The Table below presents results for SPY from 1993 to the present. We performed the tests for 2 different volatility regimes: low (VIX<=20) and high (VIX>20). Note that we have tested other lookback periods and VIX filters, but obtained qualitatively the same results.

	Number of Trades	Winner	Average trade PnL
All	455	24.8%	-0.30%
VIX<=20	217	23.5%	-0.23%
VIX>20	260	26.5%	-0.37%

It can be seen that the average PnL for all trades is -0.3%, so overall shorting SPY is a losing trade. This is not surprising, since in the short term the SP500 exhibits a strong mean reverting behavior, and in a long term it has a positive drift.

We still expected that when volatility is high, the SP500 would exhibit some momentum characteristics and short selling would be profitable. The result indicates the opposite. When VIX>20, the average trade PnL is -0.37%, which is higher (in absolute value) than the average trade PnL for the lower volatility regime and all trades combined (-0.23% and -0.3% respectively).  This result implies that the mean reversion of the SP500 is even stronger when the VIX is high.

The average trade PnL, however, does not tell the whole story. We next look at the maximum favorable excursion (MFE). Table below summarizes the results

	Average	Median	Max
VIX<=20	0.83%	0.44%	10.59%
VIX>20	1.62%	0.73%	24.25%

Despite the fact that the short SPY trade has a negative expectancy, both the average and median MFEs are positive. This means that the short SPY trades often have large unrealized gains before they are exited at the close.  Also, as volatility increases, the average, median and largest MFEs all increase.  This is consistent with the fact that higher volatility means higher risks.

The above result implies that during a sell-off, a long equity portfolio can suffer a huge drawdown before the market stabilizes and reverts. Therefore, it’s prudent to hedge long equity exposure, especially when volatility is high.

An interesting, related question arises: should we use options or futures to hedge, which one is cheaper? Based on the average trade PnL of -0.37% and gamma rent derived from the lower bound of the VIX, a back of the envelope calculation indicated that hedging using futures appears to be cheaper.

See More Here: A Simple System For Hedging Long Portfolios

We have written many blog posts about the increase in volatility of volatility. See, for example

Is Volatility of Volatility Increasing?

What Caused the Increase in Volatility of Volatility?

Similarly, last week Bloomberg reported,

The sudden rise in volatility in February and March showed that even with strong growth fundamentals, financial markets remain vulnerable. Since 2008, there have been seven flash crashes followed by sudden recoveries. Volatility has become binary, with markets swinging between periods of shock and calm. The VIX index traded at a median of 16 after the start of QE and at 18 before, but the spikes in volatility have become twice as frequent. It is the equivalent of swapping a stable drizzle rain with many days of scorching sun, at the price of occasional natural disasters. Read more

[caption id="attachment_454" align="aligncenter" width="628"] VVIX (volatility of volatility index) as at March 23 2018. Source: stockcharts.com[/caption]

The rise of the volatility of volatility increases the chance of a Black Swan event happening. Recently, we presented a study showing that a down day of 4% during a bull market is a very rare event. It happened on February 5, and before that the last time this occurred, it was 18 years ago.

We next counted the number of days when the SP500 dropped 4% or more during a bull market. We defined the bull market as price > 200-Day simple moving average.  Since 1970 there have been 5 occurrences, i.e. on average once every 10 years. We don’t know whether this qualifies as a black swan event, but a drop of more than 4% during a bull market is indeed very rare. Read more

Similarly, AQR looked at the February 5 event from the implied/realized volatility perspective.

... As of now (no predictions going forward!) this recent wild period is not super crazy when we look just at volatility itself (it’s high, but not super high vs. history). But, when we look at it as a surprise (by comparing the realized 5-day volatility to the starting VIX) it’s a considerably more shocking event, though still not unprecedented. Similar events have occurred five or so times in the 1990 - present history (again, see the above figure). Finally, when just using the simple method of targeting constant volatility that we employ here, this recent surprise swoon was, as we’d expect, pretty bad for volatility targeters. But, over the longer term, volatility targeting, even the super simple volatility targeting our toy risk-model employs, may, on average, deliver more downside stability than not volatility targeting and implicitly letting the market dictate the volatility of your investment. Read more

Again, from the implied/realized volatility point of view, the recent event was a rare occurrence, though not unprecedented. In times like this, risk management is more important than ever.

Post Source Here: Black Swan and Volatility of Volatility

On February 5, the SP500 experienced a drop of 4% in a day. We ask ourselves the question:  is a one-day 4% drop a common occurrence? The table below shows the number of 4% (or more) down days since 1970.

	4% down	4% down and bullish
From 1970	40	5

 

On average, a 4% down day occurred each 1.2 years, which is probably not a rare occurrence.

We next counted the number of days when the SP500 dropped 4% or more during a bull market. We defined the bull market as price > 200-Day simple moving average.  Since 1970 there have been 5 occurrences, i.e. on average once every 10 years. We don’t know whether this qualifies as a black swan event, but a drop of more than 4% during a bull market is indeed very rare.

The table below shows the dates of such  occurrences. It’s interesting to note that before the February 5 event, the last two 4% drops when price> 200-day SMA occurred around the dot-com period.

Date	%change
September 11, 1986	-4.8
October 13, 1989	-6.1
October 27, 1997	-6.9
April 14, 2000	-5.8
February 5, 2018	-4.1

 

Source Here: Is a 4% Down Day a Black Swan?

Last week, many traders noticed that there was a divergence between SPX and VIX. It’s true if we look at the price series. Graph below shows the 20-day rolling correlation between SPX and VIX prices for the last year. We can see that the correlation has been positive lately.

[caption id="attachment_327" align="aligncenter" width="564"] 20-day rolling correlation SPX-VIX prices, ending Jan 26 2018[/caption]

However, if we look at the correlation between SPX daily returns and VIX changes, it’s more or less in line with the long term average of -0.79. So the divergence was not significant.

[caption id="attachment_328" align="aligncenter" width="564"] 20-day rolling correlation SPX return -VIX changes ending Jan 26 2018[/caption]

The implied volatility (VIX) actually tracked the realized volatility (not shown) quite well. The latter happened to increase when the market has moved to the upside since the beginning of the year.

Originally Published Here: Correlation Between SPX and VIX