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Year of Inflection & Derivative Strategy

With 2022 in the history books, markets started the year pricing in many positive headline news. In our Year Ahead 2023 publication, we suggested that 2023 will see several inflections happening in financial markets. Some of these have happened earlier than expected, like the reopening in China. Others will require more time to materialize, e.g., falling central bank interest rates or improving economic growth. A similar outlook holds true for volatility and option markets. Implied volatility of select asset classes has quickly normalized during January (for example, in equities), while skew started to slowly rise from the depressed levels of 2022. We expect these dynamics to continue to unfold in 2023, but likely at a slower pace as compared to the past months. In 2023, we expect momentum in inflation and interest rates, to reverse, while economic growth will likely remain below trend for a while. Consequently, market volatility is expected to stay at elevated levels and only normalize later in the year. Investors should be wary and look for defensive solutions that benefit from still-elevated volatility and high interest rates.

 

By Luca Henzen
Head CIO Derivatives, UBS Global Wealth Management              
And Moritz Vontobel
CIO Derivatives, UBS Global Wealth Management                        

 

Ideas for volatility inflection

1. Selling Volatility

Short-volatility strategies benefit from high levels of implied volatility and moderate swings in the underlying asset. A way to look at them is to consider the volatility risk premium (VRP), which can be interpreted as the difference between option-implied volatility and subsequent realized volatility. In general, higher VRP leads to a higher return of short-vol strategies. As we see limited upside for equities in 2023, we favor selling put options to generate income also in sideways markets. Compared to a stock investment, yield-enhancing structures like reverse convertibles (i.e., bond + short put) also benefit from higher interest rates.

2. Defensive Participation

Thanks to the sharp rise in interest rates, the attractiveness of protection strategies with participation improved significantly in 2022. Capital protection, or capital return, strategies are among the most popular solutions, which offer upside participation to the performance of a specific underlying asset with some degree of protection on the invested capital—provided there is no issuer default event. They typically comprise a zero-coupon bond and a call option. Higher rates therefore decrease the value of the bond, allowing for a greater proportion of the capital to be invested in the call.

With better conditions linked to protection strategies, we expect that some retail activity on traditional structured products will move away from yield-enhancing solutions. This might have some repercussions for the option markets. Supply of long-dated implied volatility could indeed diminish, with demand increasing. We expect this process to be slow and conditional on interest rates remaining high. Nonetheless, the downward pressure on long-dated implied volatility of OTM puts or dividends should decline in 2023, in our view. Currently, we still recommend investors to consider decrement indexes as an alternative underlying for their structured products. Decrement indexes can reduce the impact of depressed dividends and ultimately provide more favorable parameters for structured product’s buyers.

3. Hedging

As a result of the slow equity drawdown in 2022, option based hedging strategies that are long volatility and convexity such as OTM puts were less efficient or did not work at all. Equity implied volatility indeed failed to reset higher during market corrections. As evidence, 2022 saw a record number of trading days with the US equity market and the VIX both moving down. Despite the rapid reprice of terminal rate expectations during the recent market sell-off, the fight of central banks against inflation is not over and interest rates could remain in a restrictive territory for a prolonged period. In our view, upside for equity markets is limited, and we advise adopting a defensive investment profile amid rising challenges for corporate earnings.

More exotic solutions remain attractive in the current market characterized by elevated implied volatility and thus expensive option prices. For example, hybrid options that combine a defensive profile on equities with additional conditions on a second asset class can help reduce the cost of protection.

 

UBS Global Financial Intermediaries

At UBS Global Financial Intermediaries we can support you finding the right products that fit your client’s needs. The structured products and derivatives we offer are closely aligned with our CIO’s view and can be tailored either through a self-directed multi-issuer platform with direct booking or via our dedicated capital markets specialist team.

 

 

Biographies

Luca Henzen is a derivatives analyst in the Global Asset Allocation team of the UBS Chief Investment Office. In this capacity, he is responsible for the research coverage on derivatives and structured products. Luca joined UBS CIO in 2018 working in the Investment Risk team. Prior to this, he was a portfolio manager and research analyst within the UBS Asset Management investment solutions team. He was also a member of the derivatives and equity research groups. Luca holds a Master's degree and a PhD in Microelectronics from the ETH Zurich.

Moritz Vontobel joined UBS as a cross-asset analyst in 2018. Based in Zurich, he works within the Global Asset Allocation team of the UBS Chief Investment Office, where his focus lies on options and derivatives strategies. Additionally, he provides research on tactical investment and structured product trade ideas. Moritz holds a master's degree in finance, economics and data science from the University of Zurich. He has gained experience across various business segments such as structured products, research, private markets and wealth management.  Previously he worked for Goldman Sachs and Credit Suisse in London and Zurich.