Tools for macroeconomic events

Our hearts and thoughts are with the Japanese people in this moment of darkness. From it, the volatility in financial markets, across all asset classes, has been nothing short of breathtaking and, it must be managed.

Yet, whether it was prior to or after the earthquake and tsunami, the tools to manage risk and potential return were readily available. One must also consider context when establishing a strategy or plan. For investors, the long bull run from 2002 to late 2007 would have allowed for a different strategy than that since the March 2009 low. Varying volatility and event risk are certainly more frequent, however, the tools are certainly available. This column will examine how certain tools and strategies can be employed when a macroeconomic event occurs. One example focuses on managing expected risk and the other on potential return.

For investors, the bull run from early 2002 to late 2007, only one strategy applied in general: Buy! Insurance was generally cheap over that period as seen through the VIX (the average daily level was 17.8% from 1/1/2002 to 9/28/2007) but perhaps due to complacency or lack of option liquidity or lack of understanding, it was not really part of the investing vocabulary. Event risk may have been considered as the cost of doing business or investing in risky assets. In addition, taking advantage of cheap (or relatively cheaper) foreign assets was also not as viable due to commission costs or operational complexity.

Add the global banking credit crisis, housing bubble, sovereign default risk of the PIIGS, middle east democracy movement, oil instability and event risks, such as the BP Gulf of Mexico Deepwater Horizon rig and Japanese earthquake, tsunami, and what you get is an environment where returns are available but risks need to be defined and strategized. The heightened risk is evidenced by an average daily VIX level of 27.8% from 10/1/2007 to 3/18/2011. One of the great attributes of options is their ability to clearly outline and define the risk and return.

As far as protection is concerned, to hedge portfolios, index options have been cheap since the start of the year as seen by the VIX. If an investor truly believes that their cost is a drag on performance, first consider the risk of not hedging as in the environment. Second, one can reduce the cost by buying an index put option at a certain level and selling a lower strike one (known as a “put spread”). Here, both the cost (net premium) and protection (strike levels) are clearly outlined. Protection is possible on the SPX (via SPY), NASDAQ (via QQQ), Russell 2000 (IWM) and the Dow (DIA), many international indices and even sectors.

As an aside, most investors focus on the VIX as a level of volatility, however, the CBOE has developed volatility indices on oil, gold and even individual stocks which allows investors and hedgers a more specific asset class view of implied volatility. The same strategy is possible for individual stocks but covered call options can also be sold to even further reduce the cost of the put spread purchased (the “collar”).

Let’s turn our focus now on a potential return strategy. The evolution of products has significantly increased the possibilities. An example is presenting itself even in this volatile period. The investment theme is to consider that Japanese yen will have to dramatically depreciate as the BOJ will have to print and borrow and enormous amount for the reconstruction ($300B is an estimate). This is currently being witnessed with the dramatic drop of the USD index given the Fed’s quantitative easing.

With this backdrop, many may believe that certain blue chip Japanese stocks may be cheap at these levels. Although many Japanese stocks trade on U.S. exchanges, the investor will incur inherent currency risk of the yen, dollar rate. ETFs such as the FXY (Currency Shares Japanese Yen Trust) or the YCS (Proshares UltraShort Yen) allows the investor to trade the yen currency in an effective manner.

Let’s work through an example; an investor can take a view of a Japanese stock, such as Toyota Motors, being cheap. The purchase of the shares and simultaneously either shorting the FXY or purchasing the YCS2 is the combined transaction. The end result is the investor purchasing an asset they believe is cheap while removing the volatile yen, dollar currency risk.

Both of these examples illustrate that not only are the tools are available to managing risk and return when a macroeconomic event occurs but also a clearly defined strategy is required.

We cannot predict when macroeconomic events will occur or if they really are happening more often but what is clear and certain is that a buy and hold strategy without a risk management strategy cannot be viable going forward. What is important is that the investor or fund determines what their risk tolerance is and this will define its risk culture and actions and strategy it will put in place.

Pascal Bancheri, CFA, is the president and principal of Sigma Management Advisors Inc.