Developments on the financial markets in recent years have confronted investors with unaccustomed challenges. They face a “new normality” characterised by volatile markets, slow economic growth, high unemployment and low interest rates in many developed countries. Factoring in extreme events has become an important element in the framing of investment strategy.

 

Volatility impairs returns

 

The calculation is simple: if a share falls 50%, then it has to rise by 100% to reach its previous value. However, if the loss can be limited to 25% by means of a hedging strategy, a recovery of merely 33% is enough to break even. Mathematics tells us that long-term capital appreciation is roughly equal to the arithmetic average return over the investment period less half the volatility of the return. Suppose you toss a coin and double your money on heads but lose half of it on tails. The expected return will be 25% (0.5 x 100% + 0.5 x –50%). This is an attractive outcome, but the bet will not produce an increase in value over time because the volatility inherent in tossing a coin impedes capital growth. Casinos all over the world exploit this mathematical principle.

 

Preparing for extreme risks

 

Diversification across various asset classes and markets plays an important role in reducing volatility in investment portfolios. The 2008 crisis showed, however, that in today’s tightly interconnected financial world the benefits of diversification can be sidelined by extreme events. Investors therefore need a second firewall alongside diversification. The financial services industry is now developing innovative hedging products for this purpose, but these solutions still have to prove themselves in practice.

 

Volatility – barometer of equity market sentiment

 

A strategy that has already proved effective in times of crisis is “volatility harvesting”. Volatility indices measure expected fluctuations in a given market on the basis of options prices. Thus volatility is a barometer of financial market sentiment. It tends to surge in times of stress but not stay at very elevated levels for long. Equity market volatility in April was at its lowest since 2007. Measured by the Chicago Board Options Exchange Volatility Index (VIX), the expected range of fluctuation for the S&P 500 over the next twelve months is 16% (1% a day). After the Lehman collapse, this figure jumped to as high as 90% (6% a day).

 

 

Alongside the VIX on the S&P 500 (the oldest and most popular volatility index), the Chicago Board Options Exchange also calculates 18 other volatility indices. EUREX offers trading in futures and options on a volatility index for the EURO STOXX 50. The stock exchanges in Hong Kong and Tokyo have also started offering volatility indices this year.

 

Volatility as an asset class

 

Investors have been able to trade in volatility on US futures markets since 2004, and volatility options have been tradable since 2006. Transaction volume on the volatility futures market has risen elevenfold since 2008, with a current volume of over USD 1 billion a day.

 

 

 

In the context of portfolio investment, the aim is to profit from rising volatility in a falling market and thereby reduce the overall loss on the portfolio. This has been tested empirically in a study for the period 2006–2008. The study showed that an admixture of volatility futures and options resulted in an improvement in portfolio efficiency (return in relation to risk). By comparison, repeated buying of put options produced very much worse results, reflecting the high cost of this form of hedging over the long term. In the most volatile context (August–December 2008), the inclusion of just 1% of volatility options improved the portfolio return from –19.7% to +17.7% p.a. while simultaneously reducing the risk of loss. This positive result was due mainly to the fact that the correlation of volatility with the equity market remained constantly negative even against the background of extreme events.

 

 

Volatility investment products

 

Investors who do not want to get directly involved in the derivatives markets can now gain an exposure to volatility in the form of certificates. These were launched in 2009. It is advisable to consult an expert when going down this road. Besides the counterparty risk, it should be noted that the behaviour of these products varies greatly depending on the way they are constructed. Longer futures contracts are generally more expensive than short ones, so their value falls over time (other things being equal). This results in costs when short contracts are rolled over into longer ones. Roll costs become especially important as contracts approach maturity. Products with a longer maturity involve lower roll costs but react much less sensitively. In any case, the problem of roll costs means that neither long- nor short-term products should be held as permanent positions. They are a suitable device for portfolio hedging when held for a few days or weeks at a time. The currently available products are not the last word in this young sector. We still advise private investors to combine diversification with tactical moves to reduce risk.

 

* Source: VP Bank, CBOE

 

The latest rescue package for Greece involves a debt swap with private bondholders, who will forego over 50% of their principal by exchanging old bonds for new. This should reduce Greece’s public debt by something over EUR 100 billion, bringing it down from almost 170% of GDP to under 120%.

 

That is still a high level. The success of the restructuring package will therefore depend crucially on whether Athens makes the necessary reforms to put the country back on a growth track.

 

Danger of contagion banished for time being

 

These latest measures to stave off a Greek default have reduced the danger that the contagion will spread to other peripheral Eurozone countries. Spain and Italy are probably now off the critical list. But there are still serious worries about Portugal, which remains on a drip feed from the EU and IMF.

 

Italy improves its budget position

Successful debt reduction depends on economic growth and solid budget discipline. Italy’s debt pile has now climbed to 120% of GDP. The Italian economy grew by only 0.6% per annum in the period 2000 – 2010, not nearly enough to pull the country out of its financial morass. Nevertheless, Italy has the lowest budget deficit of any of the peripheral countries. Last year it even achieved a primary surplus (budget surplus before interest payments). The country is moving in the right direction. A broad-based economy and a solid tax base should prevent an escalation of Italy’s debt problems for the time being.

 

Spain – better budget discipline needed

 

Spain’s GDP growth, at 2.2% per annum, has been faster than Italy’s. Compared with other peripheral economies, Spain has the advantage of a strong industrial base. Spanish automobile and aerospace manufacturers are successful players in international markets, and a further reduction of unit labour costs could make their products even more competitive. Spain has to grapple with a jobless rate of over 20% and a stubborn decline in real estate prices. On the fiscal front, however, it has a lower debt-to-GDP ratio than any other peripheral Eurozone country – “only” 70%. Although budget deficits have been steadily reduced since 2009, the primary deficit is still around 5% of GDP (2011 figure). This poses a risk to the country’s debt stabilisation efforts.

 

Portugal – another Greece?

 

Portugal is still a headache for the financial markets – and with good reason. The small size of the Portuguese economy does little to mitigate worries about its fiscal misère. Per capita GDP, at around USD 20,000, is significantly lower than Greece’s (USD 22,000), and this makes it all the more difficult to finance expenditure by generating additional tax revenue. Last year’s bailout measures mean that the refinancing of Portugal’s debt mountain (currently 100% of GDP) is assured until the end of 2013. Given the massive hole in the government’s budget and the ongoing recession, there is no prospect of Portugal being able to raise new capital on the markets. It is therefore merely a matter of time before a new rescue package will be needed. An additional EUR 40 billion would cover refinancing requirements until the end of 2015. Whereas Italy has been chalking up budget surpluses (before interest charges) and Spain has a relatively low debt-to-GDP ratio, Portugal does badly on both these counts. Its primary budget is chronically in the red, and its debt-to-GDP ratio of 101% is at a critically high level. If a primary budget surplus is not achieved, debt will continue to soar. The danger of a “haircut” for private creditors therefore remains.

 

First Portugal, then Spain?

 

Given the close economic links on the Iberian peninsula, there are fears that a writedown of Portuguese debt could also threaten the solvency of Spain. But the direct dangers posed by a Portuguese writedown are limited. According to the European Banking Authority, Spanish financial companies hold around EUR 5.5 billion worth of Portuguese government bonds. That represents only 0.16% of their total assets and is thus a manageable risk.

 

The role of creditors

 

Despite its difficulties, Portugal has recently been given good marks by the IMF, which believes that the country’s reform efforts will work. At the end of February the “troika” (EU, ECB and IMF) gave the green light for Portugal’s next loan tranche of EUR 14.6 billion. In contrast to Greece, there seems to be basic agreement among the negotiating partners – an important element in the battle against a possible domino effect in the Eurozone.

 

Ireland – one step ahead

 

Ireland was hit hard by the 2009 financial crisis. Public debt rocketed in the wake of the bailouts of Irish banks. Despite enormous budget deficits and a deep recession, Ireland is now the only peripheral Eurozone country that can boast a surplus on current account. Added to that, unit labour costs have been reduced significantly since 2008. The worst of the Irish crisis appears to be over, and the risk of more bad news is limited.

 

How the markets see it

 

The financial market risks posed by the Eurozone periphery have receded. Yields on 10-year Portuguese government bonds are now under 13%, down by over 400 basis points since their January peak. It should be noted, however, that this recovery was assisted by the European Central Bank, which has been buying up Portuguese bonds. Portugal’s borrowing costs are not sustainable in the long term at their current levels, so the country remains dependent on outside help. Spain and Italy’s long-term borrowing costs, by contrast, are now close to the historical average and are therefore manageable provided these countries quickly return to a growth trajectory.

 

 

 

Conclusion

 

Greece has obvious weaknesses. The macro situation in Italy and Spain is decidedly better, but Portugal still gives cause for concern. Portugal needs to regain the confidence of the financial markets quickly. A primary budget surplus for the current year would provide an important signal. If the budget is not lifted into the black, a writedown of Portuguese debt in the years ahead cannot be ruled out. Even so, there is only a limited risk of a domino effect that would topple Spain and Italy.

 

 

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Bernd Hartmann is Head of Investment Research at VP Bank Group in Vaduz, Liechtenstein. He bears responsibility for analysing currencies, bonds, equities and alternative investments, as well as for selecting fund managers and products. As a member of the Investment Tactics Committee, he is jointly in charge of determining the tactical positioning of VP Bank's portfolio management mandates. Prior to joining VP Bank, Bernd Hartmann was an equity investment fund manager at the Liechtensteinische Landesbank. He holds an MBA in financial services and a BA in business economics from the Liechtenstein University of Applied Sciences.

 

Greece’s desperate situation was foreseeable. Harsh austerity measures, falling tax revenues (due to recession and unemployment) and high interest rates have plunged the country into insolvency. Efforts to bail out Greece are apparently having dire consequences for saviours and saved alike. But focusing on just a few key data and headline-hitting events distorts awareness of what has actually been achieved.

 

 

 

It is ten years since Jim O’Neill, then top economist and now Head of Asset Management at Goldman Sachs, put forward the thesis that the four emerging economies Brazil, Russia, India and China – BRICs, as he dubbed them – would overtake the G7 by 2050. O’Neill’s catchy acronym enjoyed enormous success in the financial world.

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