Macro Risk Advisors, headed by Dean Curnutt, are specialists in derivatives strategy. One of their chief occupations is thus evaluating risk and volatility.
Given that, it’s probably fair to say they’re in a good position to comment on matters “systemic risk” related.
Here’s where it gets worrying.
Their debut monthly publication “Systemic risk outlook” describes a rather unsettling condition in the global financial system. The fact that we’ve run out of Plan Bs.
In terms of the evolution of systemic risk since 2008, they see it as follows:
To appreciate the evolution of systemic risk, consider the following chart.
Here we highlight the path of risk pricing across corporate credit, equities and sovereigns. The crisis and the deleveraging that ensued left the private sector vastly short volatility. In late 2008 we watched U.S. broker dealer CDS levels surge as share prices plummeted. In the process, clients of these firms rushed to reduce exposures (think prime brokerage balances). The risk spiral prompted responses from the Fed, Treasury and FDIC. These policy actions, in aggregate, were designed to reduce systemic risk by providing a backstop (put options) to the market place.In theory, the resources of a government are sufficiently large to be able to provide a loss-absorbing stabilizer (TARP, for example). In some cases, however, losses are so substantial that the banking system literally gobbles up the sovereign.
Understandably for a risk house, they see the solution in loading up on crisis hedges — now at bargain prices due to all that government intervention.
In particular, they stress, do not be fooled by a Vix of 18. It’s good value:
The vast degree of monetary and fiscal stimulus being applied to the market helps the VIX clear at current levels, which are below long term averages and down 27% relative to the 22 average experienced in 2010. There is considerably more systemic risk than suggested by a VIX of 18. We favor relatively short-dated option hedges, as we see very near-term sources of uncertainty (sovereign, earnings, debt ceiling) in the market. In addition, the recent sell-off in intermediate levels of SPX implied volatility and skew (3-month option premia are near the lows seen since before the crisis) has allowed us to slightly extended the duration of our option-based hedge portfolio.
Though, here’s hoping Vix and put option contracts don’t suffer the short sale banning treatment one day.
Related links:
How much is the Bernanke put worth? – FT Alphaville
Crouching Vix, hidden volatility – FT Alphaville
The calm before the (volatility) storm - FT Alphaville