The month of April saw more of the same 2019 theme – risk on, asset markets strong, and, maybe most particularly, volatility down. Across a range of asset classes and geographies we saw a continued push lower in volatility pricing, with markets accepting, and even pricing in, ongoing central bank policy accommodation always at the ready in case of weakness in equity markets; the search for yield persists in all its forms. You name it – levered, structured, securitized, risk premia, vol selling – and the investment world is piling back into it. In our little corner of the investment world, that means embedded short volatility in a seemingly never-ending proliferation of yield enhanced structured investment products.

We often talk about how the only relevant “timing”, when it comes to buying volatility/insurance, is when it is cheap/good value. What does “cheap” look like? Well, possibly you have heard us say more than once that “low doesn’t mean cheap”. We get our best impressions of cheapness by just sitting back and watching the supply pour in from all the derivative bank participants in the ‘Structured Product Game’. We recently tried to explain it to a US equity focused Vol RV manager friend. The conversation went something like this:

Vix Expert: “What’s interesting in your world today?”
Convex Member: “A certain bank just called axed to sell us variance swaps on this EM currency”
Vix Expert: “Is that a commonly traded market?”
Convex Member: “Nope. Never seen them with any interest in it before”
Vix Expert: “Why are they willing to sell something so convex and toxic on that currency?”
Convex Member: “Because volatility is at an all-time low”
Vix Expert: “Huh?”

Without going into remote EM currencies, equities, or the like, we thought we would try to give our readers an idea of what “cheap” looks like in an easily accessed market like JPY FX. The first chart is the easiest, just simple long term history of 1 year implied ATM volatility. As it has dipped below the previous all-time pre-crisis lows (the horizontal line we have drawn in), it is pretty easy to assume it is low, but this alone does not give enough information to start to build an opinion on cheapness.

Next up, we have produced a long-term graph of 6 month realized volatility. Again, not tough to see that we are at the low end of historical ranges. The horizontal line in this one is at 7.25 vol. We will come back later as to the significance of this.

Now we have shortened up the time horizon a bit in the following chart, to drill into more detail. The circle captures the specific date of April 23rd and you can see that the 1yr Implied is getting compressed right to the most recent lows around that date.

A key measure of the cost of ownership is the spread of implied over realized volatility. Likewise, right around our chosen date, that spread was crunched to a recent low.

A key driver of the cost of owning volatility is the skew or smile. In FX space the measures of these are commonly referred to as Risk Reversals and Butterflies. Yet again, around the time of our chosen date, these were at or near recent extremes in terms of cheapness.

All of these elements are giving decent indications that there is very likely “value” in JPY FX volatility/convexity around our chosen date of April 23rd. The thing that really gives it away however, if you are lucky enough to be positioned in the food chain of Structured Product volatility recycling, is a bank calling you, aggressively axed to sell 1 year JPY variance swaps, at exactly the same time. Why is a bank selling variance (volatility squared) at this point in time? As we said above, because vols are at the lows! It may seem counter-intuitive, but give us a call if you want to discuss the phenomenon.

So, look back up at the chart of historical vol and the horizontal line that we drew in at 7.25vol. That is, hypothetically, where one could have paid for a 1 year JPY variance swap on April 23rd. We would argue that all of the above combines to indicate that this could indeed be considered cheap/value. Of course, that is no guarantee that possibly paying for said variance swap at that level will make money. It can stay cheap for a long time, and even get cheaper. The point of insurance, however, isn’t to “trade it”, but rather to own what costs the least when you don’t need the insurance and pays off the most when you do. Asymmetry is the key, and a hypothetical 1yr JPY variance swap at 7.25 on April 23rd might very well be an example that fits in that category. We chart below the profit and loss sensitivity of this particular product on a deal size of $100,000, from 0vol to historical highs. Decent insurance by our definition.

One must always remember, however, that there is no such thing as a “good tail risk trade”. Proper hedging/insurance provision needs to be an ongoing process. Immediately after putting on the above trade it will start to lose sensitivity. A good “insurance” product needs to maintain or, even better, grow sensitivity through time. Efficient hedging is a constant ongoing process, free of artificial time horizons, requiring a unique discipline and patience. We find some irony in the thinking that we manage our portfolio to an indefinite future date using time sensitive securities, but most return seeking strategies manage to a relatively near term fixed date with perpetual securities. We love talking about this stuff if anybody wants to get on a call.

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