Rocky Fishman, CFA, Equity Derivatives Strategies from Deutsche Bank Securities and Philip Jones, SVP Quantitative Strategies Capital Markets Solutions, Ameriprise Financial teamed up for a session titled Equities and Rates: Hybrid Options Correlation, and Risk Management.
Fishman started out noting that the correlation between interest rates and stocks changed about 15 years ago. From the early 1960’s through 2000 there was a negative relationship, more recently it has been positive. Despite this shift there are drivers of these correlations than may be positively or negatively related. He noted in the 1980’s inflation was a concern which pushed rates up and equities down. Recently inflation has been very tame.
He then discussed Equity-rate hybrid options and noted that they break a vanilla option into a less-likely-to pay option because the payoff is subject to rates being at a certain level at payoff. He did note that there are three types of investors that may find these types of options attractive: macro investors, liability-drive investors, and target volatility investors.
Philip Jones’ section began where he noted that low volatility is best for growth investing which leans to equity investing while high volatility is a time to focus on capital preservation which favors bonds. He showed that when SPX implied volatility is around 15% a target equity allocation is 66.7% while at 40% implied volatility a target equity allocation drops to 33.3%.
He spent some time discussing gap risk considerations which I find is absent in many presentations. A recent increase in gap risk may be associated with exchange fragmentation, the rise in dynamic allocation strategy assets, and increased regulation impacting market making capacity and liquidity.