Schroders: Volatility - managing the cost of hedging

After a benign summer last year with exceptionally low volatility, markets have since experienced periods of much higher implied volatility. An initial spike in October was followed by two more in December and January as market uncertainty increased on the back of a number of factors; notably US dollar strength, plunging oil and copper prices and the currency floor removal by the Swiss National Bank. The higher and longer-lasting volatility spikes imply that equity investors are nervous and are paying up for protection.

As we have entered a period of higher volatility which is likely to last for some time, the cost of equity hedging becomes more expensive and strategies must be adjusted to avoid substantial costs. Last summer outright puts or put spreads were most attractive with low premiums and high skew, whereas both were elevated in October prompting profit-taking and applying shorter-term protection strategies.

In the current environment, with volatility and skew both moderately expensive, deciding on a strategy without either extreme volatility or skew is even more difficult. In this instance we again turn to very shortdated outright puts and put spreads to provide protection over specific events such as the European Central Bank quantitative easing announcement and remain selective in our choice of index and timing to tailor the hedges.

Term: Downside inflation risks remain

With the exception of EMD, bond markets were off to a strong start in 2015, led by sterling bond gains. Generally, the outperformance in developed markets was driven by lower inflation expectations resulting from declining energy prices and US dollar strength, as well as the uncertainty over monetary policy. Inflation expectations continue to disappoint on the downside, with energy prices influencing the market re-pricing both inflation and growth risk towards the downside over the past six months.

The bond premium remains attractive though, as most developed markets continue to show reasonably steep yield curves, albeit with notable exceptions. The latest drop in inflation expectations has caused further compression and below historical-average inflation priced into most bond markets. Real yields remain very low or negative, suggesting low growth while the inflation premium remains positive in most markets

The US 10-year Treasury yield has converged with current market pricing because of weaker inflation and less of a surprise element from monetary policy.