Challenger Investment Partners default banner

FX as an equity hedge

March 2021

This month we continue our look at more direct portfolio protection using options. In light of the possible threat to equities presented by rising rates, adding protection is a prudent measure. However, many consider equity protection too expensive as implied volatility levels have not normalised to pre-COVID levels. Although FX is not a perfect hedge, it is worth considering as a part of an overall portfolio protection strategy.

FX options too cheap to ignore

Unlike equities, FX implied volatility has returned to its pre-March 2020 level. This has caused the spread between equity and FX volatility to widen, making FX options the cheapest they have been relative to equities in many years. This presents FX options as a cost-effective hedge for tail risk.

To illustrate the effect of the lower-cost FX options, we compare the payout of the 25-delta put options in Table 1 during an equity market selloff. Based on historical co-movements, we estimate the associated change in AUDUSD and AUDJPY given a 10% and 20% S&P 500 drawdown. This allows us to calculate the payoffs of the options in 3-months, at maturity.

The payoff analysis highlights the effectiveness of FX options during left-tail events. Their low cost generates compelling returns in an acute market selloff, earning many multiples of their cost.

These results are based on the assumption that correlation profiles remain intact. AUD correlations to the S&P 500 have been quite stable over the past 5+ years, and the currency showed it continues to behave as a risk currency during the March 2020 market turmoil. However, as the name suggests, a 2nd order hedge may not always work. There have been times when this hedge has failed to capture drawdowns, such as late 2018. During the last four months of 2018, the S&P 500 fell over 15%, while AUDUSD only sold off ~2.3%. This meant the option would have had no payout despite the large equity move.

For investors who worry about the relatively high level of implied volatility in equity markets and believe equity option protection to be too expensive, FX options offer a compelling 2nd order alternative. Their low cost makes for an attractive left-tail hedge for many crisis scenarios.

The Solutions Team

The Solutions team provides derivative overlay and risk management fiduciary services to Asset Owners and Managers in Australia. Our goal is to provide asset owners and managers with an experienced overlay advisory and execution service to improve portfolio outcomes and cost efficiency.

Important notice
Financial services provided by Challenger Investment Solutions Management Pty Ltd (ABN 63 130 035 353 AFSL 487354) (CIP Asset Management, CIPAM). The material in this document is general background information about Challenger’s Investment Solutions activities and is current at the date of this document. It is information given in summary form and does not purport to be complete. It is not intended to be relied upon as advice to investors or potential investors and does not take into account the investment objectives, financial situation or needs of any particular investor. These individual circumstances should be considered with professional advice when deciding if an investment is appropriate. Nothing in this document should be considered a solicitation, offer or invitation to buy, subscribe or sell any, or a recommendation of, financial products. All reasonable care has been taken to ensure that the facts stated and opinions given in this document are fair and accurate. To the maximum extent permitted by law, the recipient releases each member of the Challenger Limited group of companies, their directors, officers, employees, representatives and advisers from any liability (including, without limitation, in respect of direct, indirect or consequential loss or damage or loss or damage arising by negligence) arising in relation to any recipient relying on anything contained in or omitted from this document. Any forward looking statements included in this presentation involve subjective judgment and analysis and are subject to significant uncertainties, risks and contingencies, many of which are outside the control of, and are unknown to, Challenger. In particular, they speak only as of the date of these materials, and they are subject to significant regulatory, business, competitive and economic uncertainties and risks. Actual future events may vary materially from forward looking statements and assumptions on which those statements are based. Given these uncertainties, recipients are cautioned not to place undue reliance on such forward looking statements. Any past performance information provided in this presentation is not a reliable indication of future performance. This document is not audited.