FX as an equity hedge
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.
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