With unemployment low and inflation expectations creeping higher, the U.S. Federal Reserve (Fed) may hike rates two or three times in 2018, and Treasury bond yields might drift a little higher. The big caveat is that this consensus scenario will only happen if inflation actually follows the script and starts to rise. Dr. Janet Yellen will no longer be Chair of the Board of Governors of the Federal Reserve System (Fed); however, the Jerome Powell-led Fed and bond market participants are likely to remain just as data dependent as was the Yellen-led Fed.
If one looks at the price of copper (Figure 1) and the implied volatility on its options (Figure 2), one might think that the metal – often referred to as Dr. Copper for its reputation as a leading prognosticator of economic health because of its widespread applications -- has returned to robust health after a bad spell from 2011 to 2015. Recently, the price has been soaring, and the implied volatility low. Fundamentally, copper looks good. The global economy is expanding robustly and growth in China, copper’s single-most important market, stopped slowing two years ago. A peek below the surface, however, shows that traders have concerns that this benign situation may not last, and 2018 could prove those concerns to be valid.
The year 2017 saw the juxtaposition of heightened policy uncertainty with relatively complacent markets and low volatility, especially in equities. Much of the policy uncertainty may find some answers in 2018. It is decision time for NAFTA and Brexit. Elections will be in the spotlight, too. Italy in March, Mexico in July, Brazil in October, and November 2018 will see a ferociously contested U.S. election for the entire House of Representatives and one-third of the Senate. At the Federal Reserve (Fed), the focus will be on inflation and the shape of the yield curve as it decides how aggressively to push rates higher or not. The weather will play a role, too, as we find out if La Niña deepens and brings droughts to Brazil and Argentina or fades away quietly.
Event risk can present some interesting risk management challenges. The two possible outcomes are typically binary in nature, like an on/off switch. Before the event, markets may price an average of the two vastly different outcomes in terms of their impact on selected products or securities. After the event, the market’s “average” of the two outcomes will definitely not survive the outcome, as markets move quickly to price the actual outcome as it becomes known. In these types of market environment, options can be a favored risk management tool. In addition, if the probability of a price break or gap is substantial around the time the outcome becomes known, the options prices will add a premium for price gap expectations in addition to the typical estimate of future volatility. This means that implied volatility calculations using models that assume price gaps/breaks do not exist (i.e., basic Black-Scholes-Merton) may over-estimate volatility by the amount of the potential price break premium.
There are also risk management considerations relative to different types of event risk. For example, political elections have known dates and unknown outcomes. Weather events, such as droughts, do not have known dates, but the general conditions that could result in a drought are known and can be monitored. In these cases, markets will price potential outcomes as probabilities shift.
Here are our favorite event risk challenges for 2018.