By: Andrew Brodbeck
The surprises of 2016 have been written about ad nauseam, but the outcomes remind us about known unknowns: event risks we are aware of, but whose outcome has unknown consequences. Many companies we talk with are comfortable with short-lived bouts of price volatility, whether commodities or foreign exchange, because it normalizes, and the way of doing business doesn’t materially change. However, persistent uncertainty that creates new price environments are more problematic for companies to manage. These known unknowns can fundamentally change the way business is done, how contracts are negotiated and how price risk is transferred along a supply chain. Look no further than the Mexican Peso to illustrate.
Below is a chart of implied volatility of USD/MXN, representing the market’s expectation of the annualized exchange rate variability. Implied vols have steadily risen since 2014, coinciding with economic data, unemployment and central bank announcements. Since the US election, however, implied vols have spiked as high as 18 percent and may be settling into a new environment. While most are quick to attribute this to the unknown impact of policy changes on the Mexican economy, the dispersion of what people believe should also be factored in as well.
Many academic papers have addressed analyst forecast dispersion to describe what a difference in opinions means for returns and risk sentiment. In addition to the stock market, the framework has also been applied to currencies to help us understand the impact on currency performance and implied volatility when forecasters disagree. The greater the size of disagreement, the more the uncertainty will be reflected in the price of the asset and its implied volatility.
Why does this matter? Many companies we speak to establish budget rates for FX or commodities by taking the forecast for a period of time and implementing their hedge program according to those levels. This approach may be adequate during periods of moderate volatility or general consensus of views, but in periods of large dispersion, a program may benefit from greater flexibility. The chart below shows the Mexican Peso spot rate forecast for the end of 2017 by analysts over the last 12 months. The magnitude of the disagreement is now quite notable with the most bullish on MXN calling for 18.50 while the most bearish at 28.00.
Two considerably different views of the world that could each be incorporated in budget setting and hedging decisions. As a result of the dispersion levels, an argument can be made for greater use of option related strategies in the hedging portfolio. Using the total number of OTC options traded as a proxy for changes in hedging behavior, the increase in November 2016 and January 2017 post-election, relative to the first half of 2016, tend to align with this view.
Source: Depository Trust and Clearing Corporation
In previous posts, my colleagues have written about VaR and hedge portfolio diversification. This idea of forecast dispersion builds on these topics, to help hedgers think about the appropriate mix of strategies as the level of uncertainty and volatility changes.