SHORTING GAMMA IN THE USD/INR OPTIONS MARKET

The premise for short gamma trades is that the options’ market consistently overprices the volatility of the underlying. This discrepancy can be interpreted as a risk premium that speculators demand from hedgers. 

A simple test suggests that this hypothesis is true for the USD/INR options market. Also, this risk premium seems to be auto-correlated. 

RESULTS FROM IMPLIED VERSUS REALIZED VOL TRADES

I took one-week implied vols and compared these with USD/INR’s realized volatility over the subsequent seven-days. I calculated the daily standard deviation of the exchange rate on a close to close basis (annualized by multiplying it with the square root of the number of trading days per year). Then I measured the difference between implied and realized vol over the period under consideration. Following are the results from this exercise for non-overlapping weekly periods (annualized):

Data: 1-week implied vols. from July 2003 to March 2009; USD/INR: Daily data from July 2003 to March 2009 

 Mean: 1.6%

Stdev: 3.5%

No. of trades: 294

Proportion of loss-making trades: 22%

Maximum: 18.7%

Minimum: -10.3%

THERE IS EVIDENCE OF MOMENTUM IN WEEKLY PERFORMANCE (VOL TERMS)

The serial correlation is about 0.52, suggesting the presence of momentum. Based on this result, I tested a historical scheme to go short gamma only if the last trade money. The results are the following (annualized):

Mean: 2.0%

Stdev: 3.3%

No. of trades: 228

Proportion of loss-making trades: 17%

Maximum: 18.7%

Minimum: -6.2%

Clearly, the performance improves on many fronts. The proportion of loss-making trades decline by 5% to just 17% and the maximum drawdown falls as well.

 SLIPPAGES AND TRANSACTION COSTS HAVE NOT BEEN ACCOUNTED FOR AND COULD BE A PROBLEM

These numbers do not account for transaction costs and implicit to this scheme is delta hedging on a daily closing basis. There are bound to be slippages on this front. 

Bloomberg is the source of all data. 

 

REVIVAL IN GLOBAL RISK APPETITE IS KEY TO A SUSTAINABLE EQUITY RALLY AT HOME; RELATIVE INSULATION FROM GLOBAL WOES HAS NOT HELPED AND WILL NOT HELP

I have made the case in the past that Indian equities are cheap by historical norms, but still not at valuation extremes of December 2002. While current pricing is consistent with healthy returns over the medium-term (5-10 years), we are still not in an environment that would be conducive to a sustained revival in equity market fortunes. Indian indexes cannot and will not rally at variance with global risk appetite. Consider the following regressions:

Sensex Total Return (%) = 19% + 0.01 * U.S. HY Excess Returns

Data: 1990 to 2007; Yearly
U.S. High Yield Excess Returns: Return over duration matched treasuries in basis points on the Lehman Brothers U.S. High Yield Index

R-squared = 0.44
t-statistic (beta) = 3.58 (P-value:0.002)

Sensex Total Return (%) = 11% + 0.01 * U.S.$ EM Excess Returns

Data: 1993 to 2007; Yearly
U.S.$ Emerging Market Excess Returns: Return over duration matched treasuries in basis points on the Lehman Brothers U.S.$ EM Index

R-squared = 0.23
t-statistic (beta) = 1.99 (P-value: 0.06)

The key message is a positive relationship between Indian stock market variation and excess returns in U.S. spread sectors. When risk premium demanded by global investors climbs, all asset classes under-perform.

Another way to look at this phenomenon is that the Indian bourses will post significant and sustainable rallies only when foreign portfolio investors return in a big way.

I do not foresee a revival in global risk appetite in the near future. The incessant flow of bad news continues. Trouble in Eastern Europe, never ending issues in the banking system, and massive fiscal deficits; all continue to keep markets on the back foot.

All of the above does not rule out a 20%-30% rally from wherever the market bottoms in the current downdraft, but the sustainability of the upswing will be questionable and I will look to reduce risk as markets move higher.