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Global Equity Volatility Insights
Understanding when risk parity risk increases

Bank of America Merrill Lynch
09 August 2016 Corrected

US
Quantifying the (bond-equity correlation) risks to risk parity
Last week's sharp sell-off in JGBs renewed concerns of forced selling by risk parity funds. While the drawdowns in US Treasuries, US equities, and ultimately risk parity portfolios were small and short-lived, the latent risk remains worth monitoring, as (i) leverage is still near max levels across a variety of risk parity parametrizations, (ii) bond allocations are historically elevated, and (iii) markets continue to be sceptical of a 2016 Fed hike. Hence we provide a simple scenario tool to help investors assess what relative moves in bonds and equities could catalyse significant deleveraging by rules-based risk parity funds running vol target overlays. For example, a -2% daily decline in the S&P 500 coupled with a -0.6% fall in 10y Treasury prices (poor diversification) could trigger a 25% deleveraging (of unlevered notional) today, whereas a -4% SPX drop and +1% bond rally (good diversification) would generate no selling pressure, underscoring the critical role played by bond-equity correlation in governing the severity of risk parity unwinds.

Europe
Buy the seasonal oil dip via bullish X-market risk reversals
Selling rich USO (WTI tracker) 3M 25d puts to fund cheaper SXEP (European Oil & Gas equity) calls is historically attractive. Indeed the number (>2) of long SXEP calls per short USO put is in the 90th %-ile since 2008. The trade leverages both our commodity strategists' 'buy the dip' view and our equity strategists' bullish outlook on the Oil & Gas sector, which has been the worst performing over the last 1M. Moreover, the average payoff of being long SXEP 3M 25d calls would have been >2x greater than USO 3M 25d calls (owing to more frequent positive returns), when sized for the same upfront cost.

Asia
Own NKY Sep/Oct calendar call at vol hit YTD low level going into the Sep BOJ
Post the Jul-16 BoJ and the announcement of a ¥28.1tn fiscal stimulus package, NKY and USDJPY 1M vols have dropped to near YTD low levels, both USDJPY and NKY 2M-1M term structures are historically steep, pricing in a slow summer. Our strategists believe Sep-16 BoJ's will likely create uncertainty, however, NKY Sep-Oct ATM fwd vol currently trades at the low end of its trading range going into BoJ's YTD. Plus, our analysis suggests a further squeeze in yield will likely be positive for the NKY. We recommend buying 1x NKY Oct 17500 call vs. selling 0.65x Sep 17250 call.

Trade update: Closing the NKY Aug/Sep put calendar trade at 0.28% premium

Korean auto-callable issuance slightly rose while NKY Uridashi issuance fell in July

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[Right Column]
Equity Derivatives
Global

Global Equity Derivatives Rsch
MLPF&S

Chintan Kotecha
Equity-Linked Analyst
MLPF&S
chintan.kotecha@baml.com

Nitin Saksena
Equity-Linked Analyst
MLPF&S
nitin.saksena@baml.com

Stefano Pascale
Equity-Linked Analyst
MLPF&S
stefano.pascale@baml.com

William Chan, CFA >>
Equity-Linked Analyst
Merrill Lynch (Hong Kong)
william.w.chan@baml.com

Jason Galazidis >>
Equity-Linked Analyst
MLI (UK)
jason.galazidis@baml.com

Anshul Gupta >>
Equity-Linked Analyst
MLI (UK)
agupta113@baml.com

Abhinandan Deb >>
Equity-Linked Analyst
MLI (UK)
abhinandan.deb@baml.com

Benjamin Bowler
Equity-Linked Analyst
MLPF&S
benjamin.bowler@baml.com

See Team Page for Full List of Contributors

Table 1: 3M volatility (weekly changes)
Implied Realized
S&P500 11.9 (-0.7) 13.2 (-0.1)
ESTX50 19.2 (-0.6) 27.7 (0.4)
FTSE 12.6 (-0.7) 18.9 (0.1)
DAX 17.8 (-1.1) 24.6 (-0.1)
NKY 21.7 (-1.1) 27.2 (-1.2)
HSI 17.5 (-0.6) 17.2 (-0.5)
KOSPI 12.6 (-0.4) 12.9 (0.5)
EEM US 18.8 (-0.8) 22.1 (-0.9)
TOP40 19.4 (0.3) 18.1 (-0.4)
RDX 28.2 (-1.6) 25.8 (-0.6)
IBOV 21.7 (0.0) 21.7 (-0.7)
ISE30 29.9 (-0.1) 27.7 (-0.4)
Source: BofA Merrill Lynch Global Research

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