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Highlights of the Week
• Market: The market suffered something of a setback, evidently led by the
weakness in the US equity market. The standard explanation appears to be
that the weak April US retail sales figures spooked the market. We find this
explanation somewhat puzzling, as we had assumed that the anemic
economy (albeit improving) was already largely discounted. We fear that
the true reasons behind the sizable correction lie elsewhere, as we
elaborated last week (“Equity Derivatives Review – Seasonality vs.
Economy,” May 8, 2009). Whatever the case may be, reactions from the
options market were muted, judging from the calmness in the VIX as well as
in the Nikkei skew and term structure.
• OECD CLI rises for March: In the meantime, key economic numbers
continue to improve here in Japan as well as overseas. The April Economy
Watchers’ Survey released by the Japan’s Cabinet Office on May 11
continues to show improvements on the domestic economic front, and the
OECD CLI 6M Change for G7 Countries rose for the first time since August
of last year (on the real time basis).
• Views on volatility: As there is seasonality to the market, volatility also
seems to possess certain seasonality on the average. We note in particular
the similarity of the declining volatility reversing its course around May-July
periods in the last three years. We are also cognizant of what we saw in 2003.
Then, in the aftermath of the collapse of the internet bubble, the market
found a bottom and volatility began to fall eventually to record low levels.
The repetition of such a performance is unlikely to take place, in our view,
until we see a more robust economic recovery.
• Risk reversals recommended: As we stated earlier, the likelihood of
further market correction and the market subsequently falling into a range
looms large, in our view. This said, the signs that the economy has begun to
improve bode well for equities longer term. We compare the current share
prices of large-cap stocks with their five-year averages and suggest riskreversal
on some of the stocks. Due to the still elevated skew, investors
will get paid to participate in the equity upside in some cases.
• A look at Japanese convertibles: Japanese convertible bonds have long
become scarce commodity, as they have fallen out of favor as funding
vehicles for most Japanese corporations (although they still do provide
cheap volatility to investors). In this publication, we offer a glimpse at
Japanese convertibles as alternative investment vehicles (rather than
the cheap source of volatility, as most liquid convertibles are very much
out-of-the-money).
Note: Since options are a decaying asset, investors who purchase options
risk losing the option premium paid to purchase the option(s). Options are
not suitable for all investors.
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