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Global Equity Volatility Insights
Understanding when risk parity risk
increases
we estimate 68% of the
09 August 2016 Corrected
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US
Quantifying the (bond-equity correlation) risks to risk parity
Last week’s sharp sell-off in JGBs renewed concerns of forced selling by risk parity
funds. While the drawdowns in US Treasuries, US equities, and ultimately risk parity
portfolios were small and short-lived, the latent risk remains worth monitoring, as (i)
leverage is still near max levels across a variety of risk parity parametrizations, (ii) bond
allocations are historically elevated, and (iii) markets continue to be sceptical of a 2016
Fed hike. Hence we provide a simple scenario tool to help investors assess what relative
moves in bonds and equities could catalyse significant deleveraging by rules-based risk
parity funds running vol target overlays. For example, a -2% daily decline in the S&P
500 coupled with a -0.6% fall in 10y Treasury prices (poor diversification) could trigger a
25% deleveraging (of unlevered notional) today, whereas a -4% SPX drop and +1% bond
rally (good diversification) would generate no selling pressure, underscoring the critical
role played by bond-equity correlation in governing the severity of risk parity unwinds.
Europe
Buy the seasonal oil dip via bullish X-market risk reversals
Selling rich USO (WTI tracker) 3M 25d puts to fund cheaper SXEP (European Oil & Gas
equity) calls is historically attractive. Indeed the number (>2) of long SXEP calls per short
USO put is in the 90 th %-ile since 2008. The trade leverages both our commodity
strategists’ ‘buy the dip’ view and our equity strategists’ bullish outlook on the Oil & Gas
sector, which has been the worst performing over the last 1M. Moreover, the average
payoff of being long SXEP 3M 25d calls would have been >2x greater than USO 3M 25d
calls (owing to more frequent positive returns), when sized for the same upfront cost.
Asia
Own NKY Sep/Oct calendar call at vol hit YTD low level going into the Sep BOJ
Post the Jul-16 BoJ and the announcement of a ¥28.1tn fiscal stimulus package, NKY and
USDJPY 1M vols have dropped to near YTD low levels, both USDJPY and NKY 2M-1M
term structures are historically steep, pricing in a slow summer. Our strategists believe
Sep-16 BoJ’s will likely create uncertainty, however, NKY Sep-Oct ATM fwd vol currently
trades at the low end of its trading range going into BoJ’s YTD. Plus, our analysis
suggests a further squeeze in yield will likely be positive for the NKY. We recommend
buying 1x NKY Oct 17500 call vs. selling 0.65x Sep 17250 call.
Trade update: Closing the NKY Aug/Sep put calendar trade at 0.28% premium
Korean auto-callable issuance slightly rose while NKY Uridashi issuance fell in July
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Refer to important disclosures on page 25 to 26. Analyst Certification on page 23. 11657850
Equity Derivatives
Global
Global Equity Derivatives Rsch
MLPF&S
Chintan Kotecha
Equity-Linked Analyst
MLPF&S
chintan.kotecha@baml.com
Nitin Saksena
Equity-Linked Analyst
MLPF&S
nitin.saksena@baml.com
Stefano Pascale
Equity-Linked Analyst
MLPF&S
stefano.pascale@baml.com
William Chan, CFA >>
Equity-Linked Analyst
Merrill Lynch (Hong Kong)
william.w.chan@baml.com
Jason Galazidis >>
Equity-Linked Analyst
MLI (UK)
jason.galazidis@baml.com
Anshul Gupta >>
Equity-Linked Analyst
MLI (UK)
agupta113@baml.com
Abhinandan Deb >>
Equity-Linked Analyst
MLI (UK)
abhinandan.deb@baml.com
Benjamin Bowler
Equity-Linked Analyst
MLPF&S
benjamin.bowler@baml.com
See Team Page for Full List of Contributors
Table 1: 3M volatility (weekly changes)
Implied Realized
S&P500 11.9 (-0.7) 13.2 (-0.1)
ESTX50 19.2 (-0.6) 27.7 (0.4)
FTSE 12.6 (-0.7) 18.9 (0.1)
DAX 17.8 (-1.1) 24.6 (-0.1)
NKY 21.7 (-1.1) 27.2 (-1.2)
HSI 17.5 (-0.6) 17.2 (-0.5)
KOSPI 12.6 (-0.4) 12.9 (0.5)
EEM US 18.8 (-0.8) 22.1 (-0.9)
TOP40 19.4 (0.3) 18.1 (-0.4)
RDX 28.2 (-1.6) 25.8 (-0.6)
IBOV 21.7 (0.0) 21.7 (-0.7)
ISE30 29.9 (-0.1) 27.7 (-0.4)
Source: BofA Merrill Lynch Global Research
BofAML GFSI TM X-Asset Risk Landscape
GFSI makes new YTD lows as BoE & NFP boost risk assets
The GFSI declined to a new YTD low of 0.18 as of 5-Aug, a level not seen since Nov-15.
With the BoE surprising to the upside in terms of cutting rates, re-starting QE and
guiding towards more accommodative policy down the line, as well as better than
expected US non-farm payrolls, risk assets globally got a boost.
• Credit experienced the biggest decline in stress across assets: Chart 3
shows that credit (followed by equities) experienced the biggest weekly stress
decline. Indeed, Chart 5 and Chart 6 show that sovereign risk as measured by IG
& sub-IG foreign sovereign bond spreads experienced the most significant
weekly declines in stress versus their history in the GFSI.
• Europe continues to be most stressed region: Chart 4 shows that Europe is
the most stressed region in the GFSI, despite the stress declines last week. USrelated
stresses which were already relatively lower vs the other regions, were
more resilient. Indeed the only significant move higher in regional stress was in
USD Libor-OIS spreads (Chart 5), which our Rates strategists view as driven by
the anticipation of US money market mutual fund reform in October.
.
Chart 1: Latest* stress across GFSI sub-components
4.0
3.0
Red shaded area highlights components in Bearish
GFSI Stress
2.0
1.0
0.0
-1.0
-2.0
3.50
Basis Swap USDJPY
1.78
Basis Swap EURUSD
1.61
1.24
Govt-OIS EUR
Bond Basis EUR
0.92
CDS Index Skew USD
Euro member Bond…
USDJPY Imp Vol
Libor-OIS USD
Comdty Imp Vol Crude
ESTX50 Skew
SP500 Skew
Nikkei Skew
USDJPY Skew
GBPUSD Imp Vol
Govt-OIS USD
EURJPY Skew
Libor-OIS GBP
Volume Flow
HY Bond Flow
CDS Index Skew EUR
Bond Basis USD
IG Foreign Sovrn Bond…
AUDJPY Skew
Equity Fund Flow EM
Nikkei Imp Vol
HY Corp CDS USD
Libor-OIS EUR
ESTX50 Imp Vol
Risk
Skew
Flow
Sub IG Foreign Sovrn…
HSI Imp Vol
Libor-OIS JPY
Green shaded area highlights components in
Bullish territory
IG Corp CDS USD
HY Corp CDS EUR
Comdty Imp Vol Gold
IG Corp CDS EUR
FTSE Imp Vol
Money Mkt Flow
Comdty Imp Vol Copper
-0.73
3Y/5Y Credit Curve EUR
-0.77
SP500 Imp Vol
-0.81
Int Rate Imp Vol USD
-0.82
EURUSD Imp Vol
-1.11
Int Rate Imp Vol EUR
Source: BofA Merrill Lynch Global Research. *Latest as of 05-Aug-16
Chart 2: Change** in stress across GFSI sub-components. The biggest moves were declines in stress; led by credit. Notably stress in GBP vol declined post BoE
0.6
Change in GFSI Stress
0.2
-0.2
-0.6
-1.0
0.26
Volume Flow
0.15
EURJPY Skew
0.13
0.11
CDS Index Skew USD
Basis Swap USDJPY
0.10
USDJPY Skew
Govt-OIS EUR
Int Rate Imp Vol USD
Govt-OIS USD
Comdty Imp Vol Copper
Source: BofA Merrill Lynch Global Research. **Latest as of 05-Aug-16. Change vs 1 week prior (29-Jul-16).
Libor-OIS USD
USDJPY Imp Vol
Money Mkt Flow
Int Rate Imp Vol EUR
HY Bond Flow
Comdty Imp Vol Gold
HY Corp CDS USD
HY Corp CDS EUR
3Y/5Y Credit Curve EUR
IG Corp CDS EUR
Comdty Imp Vol Crude
Euro member Bond…
IG Corp CDS USD
Bond Basis USD
Equity Fund Flow EM
EURUSD Imp Vol
HSI Imp Vol
Libor-OIS JPY
Libor-OIS EUR
ESTX50 Skew
AUDJPY Skew
ESTX50 Imp Vol
FTSE Imp Vol
SP500 Imp Vol
Nikkei Skew
SP500 Skew
Basis Swap EURUSD
Nikkei Imp Vol
Libor-OIS GBP
-0.22
Sub IG Foreign Sovrn…
-0.23
GBPUSD Imp Vol
-0.25
-0.43
Bond Basis EUR
IG Foreign Sovrn Bond…
-0.63
CDS Index Skew EUR
2 Global Equity Volatility Insights | 09 August 2016
The GFSI Risk Allocator favours being underweight risk assets given the distribution of
stresses within the GFSI. The percentages of Bullish, Bearish and Neutral GFSI
components (as used in the Risk Allocator) were 8.7%, 13.0% & 78.3%, respectively as
of 5-Aug. The Risk Allocator (using Bull, Bear & Neutral weights of 2, 0, 1) suggests
reducing the underweight position to 4.3% UW from last week’s 17.4% UW.
Chart 3: Stress across assets (Rates & FX are the most stressed asset
classes – credit stress declined the most last week
Chart 4: Stress across regions (Europe is the most stressed region in the
GFSI while EM is the least stressed)
0.6
0.5
0.4
0.3
0.2
0.1
0.0
-0.1
-0.2
0.01
-0.01 -0.01 -0.05
-0.12
Commodities Rates FX Equities Credit
0.1
0.1
0.0
-0.1
-0.1
-0.2
0.03
-0.11 -0.11 -0.11
US Japan Europe EM
Latest stress (05-Aug-16)
Change in stress
Latest stress (05-Aug-16)
Change in stress
Source: BofA Merrill Lynch Global Research. 1wk change (22-Jul-16 to 29-Jul-16).
Source: BofA Merrill Lynch Global Research. 1wk change (22-Jul-16 to 29-Jul-16).
Chart 5: Top 10 movers in stress (1-week abs chg %-ile vs history*)
Stress fall
Stress rise
100% 99%
100%
95% 93%
90%
85%
81% 80% 78% 77%
80%
69%
70%
%-ile of abs chg in stress vs history*
60%
50%
IG Foreign Sovrn
Bond Spread
Sub IG Foreign
Sovrn Bond…
Libor-OIS GBP
CDS Index Skew
EUR
GBPUSD Imp Vol
Libor-OIS JPY
Comdty Imp Vol
Copper
Basis Swap
EURUSD
Libor-OIS USD
Libor-OIS EUR
Chart 6: Global volatility & credit spread stress in the GFSI
0.4
0.2
0.0
-0.2
-0.4
-0.6
-0.8
-1.0
-1.2
Latest stress (05-Aug-16)
0.04 0.01
Rates Vol
Commodity Vol
HY CDS
-0.01 -0.03
IG CDS
Change in stress
FX Vol
-0.08 -0.10
Equity Vol
-0.23
Sovrn risk
Source: BofA Merrill Lynch Global Research. * %-ile of weekly move in stress vs all historical weekly
moves (earliest 3-Jan-00). Bar colours represent rise (red) or fall (green) in stress. 1wk change (22-Jul-
16 to 29-Jul-16).
Source: BofA Merrill Lynch Global Research. 1wk change (22-Jul-16 to 29-Jul-16).
Global Equity Volatility Insights | 09 August 2016 3
Volatility in the US
Quantifying the (bond-equity correl) risks to risk parity
Last week’s sharp sell-off in JGBs (Chart 7) following the BoJ’s decision not to cut rates
renewed investor fears of forced selling by risk parity funds. However, the spill-over
into US Treasuries was relatively muted (Chart 7), and coupled with a small and fleeting
drawdown in US equities, risk parity portfolio volatility failed to rise materially (Chart 8).
Consequently, risk parity funds were likely forced to unwind little to none of their
leverage last week and remain near max leverage levels (Chart 9).
For this very reason, the latent risk in this corner of the quant fund space remains worth
monitoring. Furthermore, as we noted post-Brexit, fixed income allocations within risk
parity funds are historically elevated today. And with federal-funds futures markets
implying a ~25% chance of a Sep rate hike and less than a 50% probability of a Dec
hike, bond markets may be surprised by a 2016 Fed hike.
Chart 7: Last week’s sharp sell-off in JGBs did
not spill-over into US Treasuries
104
103
102
101
100
99
Jan-16 Apr-16 Jul-16
10y JGB futures total return
108
106
104
102
100
98
10y UST futures total return (right)
Source: BofA Merrill Lynch Global Research. Daily data from 4-
Jan-16 through 5-Aug-16.
Chart 8: Consequently, risk parity portfolio
volatility remained quite muted
10%
9%
8%
7%
6%
5%
4%
3%
2%
Aug-
12
Aug-
13
Aug-
14
Aug-
15
Aug-
16
Historical volatility of unlevered risk
parity portfolio
Source: BofA Merrill Lynch Global Research. Equity, fixed income,
and commodity components within the hypothetical risk parity
investment are represented by the S&P500, 10-Year US Treasury
Bonds, and the S&P GSCI Index respectively. Risk parity
allocations are determined and rebalanced monthly using prior
12-month realized volatility and correlations. Historical volatility
calculated using EWMA with a lambda equal to 0.94.
Chart 9: Hence risk parity funds did not delever
materially and remain highly levered
3
2.5
2
1.5
1
0.5
Dec-12 Dec-13 Dec-14 Dec-15
LOW Vol Target (6%) & Lvg (1.5x)
MEDIUM Vol Target (8%) & Lvg (2x)
HIGH Vol Target (10%) & Lvg (3x)
Source: BofA Merrill Lynch Global Research. Daily data from 31-
Dec-12 through 27-Jun-16. Equity, fixed income, and commodity
components within the hypothetical risk parity investment are
represented by the S&P500, 10-Year US Treasury Bonds, and the
S&P GSCI Index, respectively. Risk parity allocations are
determined and rebalanced monthly using prior 12-month
realized volatility and correlations.
Monitoring relative equity/bond moves for potential risk parity deleveraging
It is intuitive to think that rising volatility corresponds to an increase in model-driven
selling pressure from risk parity strategies. However, what’s less appreciated in our
view is the impact on risk parity allocations as a result of the relative dynamics
between component volatilities and correlation. For example, through the close on the
Monday post-Brexit (27-Jun-16), S&P 500 volatility rose from 9.6% two days prior to
17.9% (increase of 1.9x) while 10-Year US Treasury Futures return volatility rose 4.3%
to 6.6% (increase of 1.5x). Despite these outsized vol moves, in a recent report we
showed that owing to the diversification (increasingly negative correlation) between
equities and bonds, unlevered risk parity portfolio volatility remained stable and hence,
target vol overlays were less likely to be subject to model-driven selling.
Given low levels of realized volatility across asset classes, it’s also intuitive to expect
continued elevated levels of leverage in risk parity products. To the extent that the
leverage is via vol control overlays, there are reasonable concerns on the potential
market impact should these model-driven investments be forced to simultaneously
deleverage. To that end, we provide a simple scenario tool (Chart 10) to help investors
assess what relative moves in the S&P 500 and 10-year US Treasury futures could
catalyze significant deleveraging by rules-based, vol-controlled risk parity funds.
4 Global Equity Volatility Insights | 09 August 2016
Importantly, this scenario tool is a function of (1) current unlevered risk parity volatility,
(2) current risk parity component weights, and (3) the maximum leverage of the target
volatility overlay. For simplicity, we used only a two asset risk parity portfolio of equity
and fixed income applied to the S&P 500 and 10-Year US Treasury Futures.
Chart 10: Current theoretical deleveraging amounts (of unlevered notional) for an equity/fixed
income risk parity portfolio with an 8% target volatility overlay and 2x max leverage cap
Assumes a trailing unlevered volatility of 3.1%, unlevered equity and fixed income weights of 22% and 78% respectively,
and leverage at a maximum of 2.0 times
5%
Daily 10-year USD Treasury Futures Total Return
4%
3%
2%
1%
0%
-1%
-2%
-3%
-4%
Brexit
Aug-15 Risk Flare
Taper Tantrum
-5%
-5% -4% -3% -2% -1% 0% 1% 2% 3% 4% 5%
Daily S&P 500 Total Return
> 50% Delever 50% to 25% Delever 25% to 0% Delever No Delever
Source: BofA Merrill Lynch Global Research. Data as of 5-Aug-16. Equity and fixed income components within the theoretical risk parity
investment are represented by S&P 500 total return and 10-Year US Treasury Futures total return. Risk parity allocations are determined
monthly and rebalanced using prior 12-month realized volatility. Unlevered portfolio volatility for determining target volatility leverage
measured using EWMA with lambda equal to 0.94.
For example, last Friday 10-Year US Treasury futures declined about 60bps. Had the
S&P 500 declined 2.0%, we would have expected about 25% of the unlevered notional
of a model 8% vol-targeted, 2.0x max leverage risk parity portfolio to deleverage. The
S&P 500 was in fact up 86bps on a total return basis which according to the tool falls in
the region of no deleveraging.
Also, to put recent events in perspective, we plotted on the scenario tool the respective
moves in the S&P 500 and 10-Year US Treasury futures during the Taper Tantrum (19-
Jun-2013), the Aug-15 risk flare (24-Aug-15), and post-Brexit (24-Jun-2016). Note, for
an accurate assessment through those events, we would also need to reconfigure the
scenario tool for the respective unlevered risk parity volatility and risk parity component
weights on those dates. However, with current measures for both, the tool does
estimate current deleveraging flows should we see similar equity and bond moves today.
Interestingly, equity/bond moves through the Aug-15 risk flare would not cause a
deleveraging today. The reason is bonds have increased in allocation since last August
(78% vs. 66%), and hence the portfolio is more resilient towards equity market declines
(but consequently also more sensitive to fixed income declines).
The scenario tool also underscores impact on risk parity leverage as a result of the
relative dynamics between component volatility and correlation. For example, the first
and third quadrants (upper right and lower left sections) are dominated by scenarios of
greater than 50% deleveraging. On the other hand, the second and fourth quadrants
Global Equity Volatility Insights | 09 August 2016 5
have episodes of more benign model-driven deleveraging. In each quadrant exists
examples of simultaneously increasing equity and bond volatility (that is, high absolute
equity and bond daily returns). However, in the first and third quadrant, equity and bond
moves are in the same direction, which would likely be an example of increasing