About two weeks ago, I participated in a discussion on Nikkei CNBC (a business news channel in Japan) about economic and geopolitical events that impact the market. Event risk is a reoccurring theme and it’s important for risk managers to continually evaluate the right mix of hedge ratios, duration and tools with this in mind.
Brexit, central bank meetings, and the Dutch elections are just a few of the recent headlines. In the weeks leading up to the U.S. Federal Reserve meeting on March 15th, strong US economic data and hawkish rhetoric from Fed members helped fuel a stronger US dollar and bullish stock market sentiment. In addition, implied volatility in currencies had fallen multi month lows (ex. CAD and JPY) despite the event risk.
While the Fed raised interest rates in line with expectations, its tone was more dovish than expected, which as a result, increased the uncertainty of future interest rate hikes. The outcome took many market participants by surprise and there was a shift in the sentiment across commodities, currencies, equities and interest rates. The dollar fell in value against world currencies, emerging markets and commodities markets rallied, and U.S. interest rates declined. The market “consensus” was surprised again. In hindsight, low volatility made options a good value for the insurance they provide. In the case of the USD and JPY, there has been movement of more than 3% from 114 to recent lows near 110, with implied volatility increasing across the curve.
We operate in an environment driven by event risk and I don’t think this will be the last surprise we see this year. The uncertainty of this environment illustrates a great example of why a diversified portfolio and mix of tools (spot, forwards, options, structures) can help companies use their volatility to their advantage through increased flexibility.