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Chart 27: SX5E 2Y var convexity (var strike vs. ATMf vol) has been driven lower by (A) a decline in the Tail liquidity Risk Premium and (B) volatility skew becoming more linear (i.e., less convex in strike)

(A) VarSwap - 1dStrip TRP
(B) VarSwap - Linear skew approximation*
(A) + (B)
VarSwap - ATMf vol

[Chart showing volatility percentages ranging from 0% to 8% from Sep12 to May17]

Source: BofA Merrill Lynch Global Research. Data: 21-Sep-16 to 31-May-17. *Linear approximation of variance strike = ATMf vol squared x (1 + 3 x T x skew squared), where T is time to maturity and skew = [ implied vol at strike 90 – implied vol at strike 100 ] / [ 90 – 100 ]. For more details see Derman’s 1999 paper: More than you ever wanted to know about volatility swaps.

We recently noted that ESTX50 long-dated (2Y) variance convexity (var strike vs. ATMf vol) had declined considerably in recent months. This has been driven by (A) a decline in the Tail liquidity Risk Premium (as defined in our piece More to variance swaps than meets the eye) and (B) volatility skew becoming more linear (i.e., 80-90 skew being similar to 90-100 skew). Both these components of variance convexity suggest that long-dated ESTX50 tails (e.g., VarSwaps or far OTM puts) are historically cheap vs. ATMf vol.

Chart 28: GBPUSD short-dated (1wk) implied has reached its 92nd 4yr percentile ahead of the UK snap election on 8-Jun. It is, however, still at least 2.7v below the levels witnessed ahead of previous known events.

[Chart showing volatility trends with annotations: Sep-14 Scottish referendum, May-15 UK general election, Jun-16 Brexit vote, Jan-17 Brexit supreme court ruling, Jun-17 snap UK election]

FTSE 100 1wk vol
GBPUSD 1wk vol

Source: BofA Merrill Lynch Global Research. Data from 5-Jun-13 to 5-Jun-17

With the UK parliamentary elections less than one week away, short-dated (1wk) implied vols on both the FTSE and GBPUSD appear more elevated vs. history, compared to last week. GBPUSD 1wk ATM vol is exhibiting some concern as it is trading in its 92nd 4yr percentile. It is, however, still at least 2.7v lower than the same measure ahead of previous known political events. In contrast, FTSE 1wk ATMf implied vol is still well below 4yr median levels.

Deutsche Tel has run too fast too quickly; hedge using a Sep17 +17P/-18C collar
BofAML equity telecom analysts have reiterated their recommendation to be cautious on Deutsche Tel as the company may face regulatory hurdles in their T-Mobile merger. Given the stock has outperformed European telcos (SXKP) by 15.1% over the past 1 year, investors who own the stock should consider hedging downside with a long DTE GY Sep17 17 put, short DTE GY Sep17 18 call for 0.46%, in our view. Indeed, spending 0.46% to protect gains is attractive as the price of the structure has rarely been cheaper (only 14% of the time since Jun-08, Chart 29). Moreover, Chart 30 illustrates that this structure enables stock owners to protect from losses greater than 2.1% while retaining 3.6% upside potential if the stock rises to 18 (near its 15-year high) by the Sep expiry.

14 Global Equity Volatility Insights | 06 June 2017
Bank of America Merrill Lynch
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