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Valtteri Ahti Ph.D +358 9 4766 9773 [email protected] Niklas Tapola +358 9 4766 9195 [email protected] September is flush with juicy events. A new country to bomb, the monetary supertanker known as the Fed finally begins to steer towards normalcy, the Iron Lady of Europe is re-elected and Doctor Sleep by Stephen King, the sequel to The Shining is finally published. What all these events have in common is that their outcomes are known with a high degree of certainty. But if so, why is the option market exhibiting signs of nervousness? We think it shouldn’t. Embrace the premium. The key event this month – as usual - is the FOMC meeting press conference on the 18 Other events include smacking Bashar with a few hundred cruise missiles and re-electing the Iron Lady of Europe on the 22 . Still it’s a sad time and political pundits will remember this as the time when western powers great and small came to grips with financial realities and dictators around the world slept a bit sounder. th. nd What these events have in common is near certainty over outcomes. We know, having seen that US macro data has been sufficiently robust (see Exhibit 1), that the Fed will initiate tapering. We know Damascus will burn. We know that Angela Merkel will emerge triumphant in the German elections. But, but… Implied volatility – a measure of market anxiety - is flirting with levels last seen in June (see Exhibit 2). Furthermore options brokers fret about implied volatility behaving strangely. But how can this be if all major outcomes are for all practical purposes known? To quote Donald Rumsfeld – whom we here at Evil Bank naturally revere - is there a known unknown at play? It’s harder to speculate about unknown unknowns, but options markets are pricing a known unknown. Perhaps given the sheer number of events, some sort of tail event is likelier. Frankly this line of thinking gets fuzzy if not downright ridiculous. Sell side strategy does involve a dash of alchemy, but this is taking thinks too far. So the natural conclusion is to use elevated implied volatility and bet against it. Note that this does not mean betting the house. One can be short volatility without being short tail outcomes. For an example see this option strategy, known as the Iron Condor. Incidentally if one has followed the dynamic Financial Times duo of Messieurs Authers and Mackintosh, they have come up with the realization that the recent emerging markets stampede applies only to those emerging markets that are net importers, i.e. countries running current account deficits. See the link above for currency appreciation/depreciation. In Exhibit 3 we show that the same phenomenon applies to stock indices as well. Countries enjoying current account surpluses have emerged () relatively unscathed. Hence those hunting the bargain basement for contrarian moves are best advised doing so by selecting deficit ridden countries. Gentlemen Prefer Bonds August 2013 On a bond market gone bonkers. Markets Overreact to Fed July 2013 In the short run markets overreact to Fed, but the secular bull run in Government bonds ends here. The US can handle the punishment, but how will a sclerotic Europe handle dearer financing? Economic Growth and Stock Market Returns June 2013 Stock markets overprice economic growth prospects. Bernanke in the Rye May 2013 Discussion on what’s driving the market, with a particular focus on central banks. A Spoonful of Inflation helps the Medicine go down May 2013 Why do we strive for 2 % inflation, why not just go for zero? Macro Drift; a market anomaly April 2013 An asset allocation anomaly that is similar to post earnings announcement drift. Dynamic Put Spread Overlay Systematically writing put spreads subject to prevailing implied volatility. We did some computations on other underlying indices. Enhanced Momentum Modeling: Developed Countries A follow study of enhanced momentum models – BAMM – see below. This study applies the same methodology to countries included in the MSCI World All Country index. An unpublished study applied BAMM to Finnish single stocks, with significant success. Enhanced Momentum Modeling: White Paper Adjusting momentum signals according to market beta improves both nominal and risk adjusted returns. The paper was inspired by the “Betting against Beta” literature. Paper includes a case study that uses STOXX 600 Europe sectors. Global Macro Momentum and Asset Allocation Asset allocators like to use PMIs and PMI momentum as gauges of “macroeconomic momentum” as decision inputs. In this paper we take a look their efficacy and what sort of measures one should use. Macro Momentum: Country Selection We build long only and long short portfolios of major countries using economic momentum (3 month changes in PMI). Pooling Leading Indicators A long piece on a tedious subject. The idea here is that instead of picking the best leading indicator – CB LEI, OECD, etc - one can extract the predictive power of the best leading indicator, but reduce the number of false signals by pooling all leading indicators. It is portfolio theory applied to leading indicators. This information material (the “Material”) has been prepared by Evli Bank Plc (“Evli”). Author: Valtteri Ahti Evli and its affiliated companies, may from time to time deal in, profit from the trading of, hold or act as market-makers or act as advisers, brokers or bankers in relation to the companies and securities, or derivatives thereof, mentioned in the Material. 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