Many traders rely on volatility-based measures of risk, such as Sharpe ratios.
He argues fund managers should be looking not at volatility but convexity – the relationship between the volatility of an asset or currency and its potential to change.
“In low-volatility environments, traditional risk measures like realized volatility, as measured by standard deviation of returns, are not adequate to capture true risks and may in fact be misleading,” he says. “This is because when volatility is low, the real risk is not the level of volatility but rather its potential to change quickly.”
This risk is captured by convexity, adds Koulajian, explaining: “Convexity is a far more relevant risk in today’s market as it predicts draw-downs more accurately than volatility. Convexity measures today are indicating that there is a significantly higher risk of very large events that could be multiple standard deviation or more.”
The years since the global financial crisis in 2008 have seen a steady compression of volatility across the markets, suppressing returns and pushing many into higher-yielding assets.
As in many markets, volatility in FX has been in the bottom 10% of its long-term range. According to data from Bloomberg, the average realized volatility for EUR/USD for the one-year period ending July 21, 2017, was 7.41%. It was 9.91% for the one-year period ending July 21, 2016.
This is also seen in lower volumes – a proxy for volatility, says Robert Franolic, head of quantitative analytics at CLS.
Average daily spot volume in the first half of 2016 was $491 billion, compared with $442 billion this year, according to CLS. Average daily EUR/USD spot volume for the one-year period ending on July 21, 2017, was $115 billion, down from $135 billion for the same period the previous year.
Turning to the carry trade
In this environment, many FX managers are turning to the carry trade.
|Said Haidar, Haidar|
Said Haidar, CEO of Haidar Capital Management, another NY-based hedge fund, says: “The best opportunities are in carry, funding with US dollars, yen, Swiss francs, sterling or New Zealand dollars and buying emerging-market currencies, Scandies or euros.”
With volatility so low, many managers have built up large positions in such trades, but this leaves them exposed to the risk of short but pronounced bouts of intra-day volatility, which can expand quickly and bury traders under losses before it falls back again.
Such was the case recently in the renminbi market, when many traders who had been positioning in expectation of a revaluation were caught out by a 10% correction that moved the market against them.
Haidar says: “The best strategy is often to do nothing. Currency moves seem to have a 48-hour half-life; they quickly revert to the mean. There is little time to buy rising currencies before they fall back, so trading short-term momentum is impossible.”
When markets move against you, the most profitable strategy has often been to hold the position, he says, adding: “It makes sense to keep positions small so you don’t get forced out by your stop-losses. But it is hard to buy the dips, too, because it means increasing the risk in your portfolio.”
Such bouts of intra-day volatility are often driven by political developments. Statements relating to Brexit drive sterling pairs, while proclamations from US president Donald Trump create pockets of brief volatility in US dollar pairs.
Volatility is therefore unevenly distributed across the FX market – and hard to predict.
CLS data show that on January 26 USD/MXN volumes spiked when the Mexican president Enrique Peña Nieto cancelled a meeting with Trump, driving down the Mexican peso.
On February 22, euro volumes surged in a number of pairs amid growing concerns about France’s presidential election campaign. And sterling volumes spiked on March 29 when the UK invoked Article 50 of the Lisbon Treaty, before peaking on April 18 when prime minister Theresa May called a snap general election.
Quest’s Koulajian notes these occasional corrections that create intra-day volatility are getting smaller and smaller. Central banks step in at certain levels and the market has learned to anticipate their actions. And with so much liquidity in the system now, managers are quicker to buy dips, which helps make them smaller.
“It has created an artificial sense of safety, with reality drifting further and further away,” he says. “A lot of managers are learning bad habits.”
In 2016, central banks between them made their largest-ever asset purchases, acquiring an estimated $4 trillion of traded securities, despite US and European economies being in relatively good health.
Central banks remain eager to maintain orderly markets, but like a patient building a tolerance to drugs and requiring ever-larger doses, markets need increasing doses of ultra-loose monetary policy to achieve the same results.
For now, it looks like markets will continue to get their fix. No major country is in recession and global growth is generally healthy, but with inflation seemingly in its box, central banks do not appear to be in a rush to raise rates – with Canada the only notable exception.
Haidar says: “The only thing that looks likely to end the central bank put is a dramatic increase in inflation, which does not look likely for the foreseeable future – if anything the inflation risk in the US is on the downside.”
There is even increasing talk that the US rate hiking cycle could end sooner than expected, with some predicting Trump could name a new and more dovish Fed chairman.
The risk is, with inflation kept at low levels, central banks will have nothing left in their arsenals to calm markets in the event of a geopolitical shock, for example an escalation of hostilities in Korea.
There are signs of increasing concern, such as the appreciation of gold, and when something does shock the market out of its current state of insouciance, what looked like a diversified portfolio of carry trades will become highly correlated.
Identifying where convexity is mispriced and entering quickly when prices break-out from periods of price compression, before exiting after a specific periods – even if the trade is still making money – is a hedge against that risk, says Koulajian.
“Essentially, the strategy acts like a put option on the market, but at a cheaper cost than carrying an option position,” he adds.