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Volatility in Asia
Long HSCEI-SPX volatility spread via corridor variance
Global synchronized monetary tightening is positive for EM vol
Emerging markets have been the biggest beneficiaries of the central bank-fueled abundance of liquidity. However, we think the tide may be turning as last week, the Fed, ECB, and BOE all delivered policy announcements with hawkish tones. How far they really go to tighten policy when economic data is weakening still remains unknown. However, we think the uncertainty surrounding tightening will be more positive for EM volatility than for DM volatility.

Chinese banks: Rapid increase in leverage is a big concern
The HSCEI currently has a 70% weight in the financial sector. Recently, BofAML analyst Winnie Wu turned very bearish on the sector as (1) leverage has rapidly increased—debt to GDP rose by 18% in 2016 and may go above 300% by 2019, (2) shadow banking has become too big, too complicated, and too levered to easily regulate—even at the highest quality bank, China Merchants, off-balance sheet wealth management products (WMP) have grown to 40% the size of on-balance sheet assets from just 18% two years ago, and (3) excessive home price inflation—low and middle-income households are late to the party and a correction in prices could have a systemic effect as property assets have been used as collateral in WMPs.

SPX: The Fed is now “collaring” the market
Since the global financial crisis the Fed has been well known for providing a put option by its willingness to step in during periods of market stress. However, post the Fed meeting last week, it appears the central bank has decided to cap its monetary support as some FOMC members seem worried that financial conditions are too loose.
Effectively, the market is now “collared” (more so for the SPX compared to EM) as the downside is protected by the Fed put (though with a lower strike price) while the upside is capped by log-jammed fiscal policy and positioning, where the risk of quant funds selling record equity positions meets cashed-up investors still accustomed to buying-the-dip.

The depressed implied China vs. US risks should reverse
With the steep drop in global risk premium, the HSCEI-SPX 18-month variance swap spread has fallen back to the lower-end of its 5-year trading range. Since we believe the global synchronized monetary tightening will impact HSCEI volatility more than SPX volatility, we recommend owning HSCEI-SPX 70/110% corridor variance at 5 vol points, a 3 vol point discount to vanilla variance spreads. Investors will be exposed to the realized vol spread between HSCEI and SPX as long as HSCEI stays within 70-110% of its initial level. Pricing of corridor variance is cheaper than vanilla variance as investors can avoid paying for the rich HSCEI convexity below the 70% barrier. The trade has a positive carry and benefits during China risk-off events.

Note that the potential HSCEI index enhancement will reduce the financial weightings in HSCEI from 70% to 50% and lower realized volatility by 1.8 vol points. However, the enhancement will be implemented in stages. It will probably start in Dec-17 at the earliest and will not be fully implemented by the end of 2018, in our view.

Indicative pricing (As of 19-Jun-17)
Buy HSCEI-SPX Dec-18 70/110% corridor variance swap: 5 vol points

16 Global Equity Volatility Insights | 20 June 2017
Bank of America Merrill Lynch
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