Apr 2, 2013

Gold, Volatility and Derivatives – Striking a Balance Between Fear & Greed

Numerix FX expert Udi Sela joins CMO and host James Jockle to discuss the sharp decline in gold prices – examining potential market drivers and the role derivatives have played.  Udi provides insight into the correlation between the options market and gold – and discusses the repercussions we’re seeing for some volatility products.

In the near term as gold begins to stabilize, Udi also explains the outlook for convertibles and other types of structures – like variance swaps and exotic derivatives and in summary discusses the potential implications for gold and volatility on second quarter results.

Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section below.


Video Transcript: Gold, Volatility and Dynamic Derivatives Hedging – Striking a Balance

Jim Jockle (Host): Hi welcome to Numerix video blog I’m your host Jim Jockle. With me today FX expert, Udi Sela, Udi how are you Sir?  

Udi Sela (Guest): Thank you, everything well. Thank you.   

Jockle: Welcome back to the blog. Want to talk to you about gold. Gold plummeted to a two year low of U.S. $1,336 per ounce earlier this week and greatly reported by Christopher Whittall of IFR magazine, in a piece called Derivatives Fuel Violent Gold Swings, really want to drill down with you Udi on elements of the implications of derivative products. In the article there was a great quote by Jerome Bussiere, Global Head of Precious Metal Derivatives at HSBC, stating “the options market also exerted downward pressure on Gold, the binary nature of the gold options market means there are long periods of quiet, followed by sudden increasingly violent moves.” Can you give us a little bit of insight into the correlation between the options market and gold?  

Sela: Yes but they just need to explain a bit how it works. So in essence, gold has always been perceived as a tool against inflation, or is a safe investment, it’s almost better than putting dollars underneath your mattress. The difference is dollars underneath your mattress cannot go up, but gold could. Over the years it has been perceived that there’s a tool against inflation, because if all the different currencies are devalued, gold would retain its value. What happened was that since the subprime crisis, the gold has been perceived as a safe haven, and more and more people have been buying gold and actually this cycle had even started in the early 2000’s where gold traded at about $250 the lowest at one ounce, this was just after the central banks were selling gold, and with time gold kept on creeping higher and eventually it got to the levels of almost $2,000 an ounce.

Now what happened was, the people that were buying gold, some of them were investors, some of them were retail, and eventually also hedge funds went into the game, and people started buying protection using derivatives, against the downside, so why would you buy, you’d buy a put option, so this is one of the dynamics of derivatives hedging. Now with time also, private banks started to offer gold related structures, and these of nature were more binary, where basically the client is selling a put option that would knock-in, at a certain level of gold has been breached so you think of a put option that say struck at let’s say at $1,700 an ounce, the act that only below $1,500, $1,400 and so forth.

So this week there was a trigger when eventually the GDP numbers from China were not as good as expected so something like 7.7 percent growth instead of 7.9 that the market expected, and as a result the investors started to perceive the debt means a slowdown, so if there’s a slowdown, there’s no need to for inflation protection, and this started to trigger sales in the selling of dollar contracts. Both listed and OTC, and as a result, people that were short the options what we call in options terminology, short GAMMA, had to sell more gold to be at DELTA neutral, and eventually this started to push the market lower and lower, until the level where these binary triggers were met, and this triggered additional sell, and as a result, the actual volatility was much higher than anticipated and this is why we saw these massive swings, and probably the market is still short GAMMA, this is why we still see the market hasn’t really stabilized, although it’s less valued.

Jockle: You bring up a very good point in regards to volatility, when we think about the VIX, Monday we’re up 43%, Tuesday we’re down 19%, and then we’re back up on Wednesday at 18%. Talk about repercussions as we’re seeing for volatility products at the whole as well as other products that are pegged to the VIX.

Sela: Yes so I’m glad you asked that because there’s a tendency that in the market when the underlined assets volatility proceed to be stable to sell volatility, so I actually took a look before this session on the differences between the historical vol., so what was the actual fluctuation of the underlined asset in this case the gold, and the implied volatility, how much the traders were willing to pay. So eventually, we can see that traders were selling volatility too cheap, and the historical volatility up to 3 months, was about 4 vols higher than the implied volatility. So people were underpricing volatility because people felt too safe, and as a result, we saw this massive swing, and basically it means the people now, people need to buy back volatility options; traders are short GAMMA as we call it, so any valid move is bad for them. And this is why volatility is now so high.

Jockle: So looking at winners and losers at this juncture and I know it is very early to do so but really, one of the elements of the article that was focusing on was impact on convertibles and as other types of structures – variance swaps, exotic derivatives, what do you see now in the year term, as we’re returning to more stability around the gold price.

Sela: So I could definitely envision, you know those are typically there to trace for us and many times they win. It’s like the first players of gold that took the most of the movement, while the late joiners got hammered, and that’s typically the basis. So if you look now, and you know we always say the tradeoff between fear and greed. So now fear is prevailing, so those who dare to be greedy, just like Warren Buffet, are probably well in place to make a good investment, I would think assuming this week’s cannot sustain, this would be perhaps be a good level to perform a VaR swap, or maybe it’s time to enter structures that could actually make you sell volatility. You know like buying no touch options etc.

Jockle: So one final question for you Udi, we’re in the midst of earning season, how do you think this is going to play out in terms of impacting second quarter results?

Udi: Probably the impact will be big on mining companies, because now, these are the companies that are really exposed to gold. So those companies that did not hedge their gold with us, will probably take a significant hit it could be 10-15% in the operation and operating margins, and those that hedge properly will be in much better shape. What is the proportion I really do not know.

Jockle: And what about just looking at the financial sector as well. Would you anticipate more trading losses to be reported going into the quarter, or do you think it’s going to smooth out over time?

Udi: So you know, typically the big banks, love volatility, volatility is good. There’s big ask spread open. And no one knows where the market is.

Jockle: Well Udi if we did have the crystal ball I’m sure you and I would be having a different conversation. I want to thank you so much for your participation yet again on the Numerix Video Blog, and join the conversation and follow us LinkedIn, or as well our blog and on twitter @nxanalytics, and we’re always happy to take any question you have. Udi thank you so much, and we look forward to seeing you next time. Thank you.

Udi: Thank you for having me. Good bye.                                   

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Improving Risk Management and Transparency for Structured Products

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