Insurance against disaster

Bank Of America: It's Time To Buy Insurance Against A Market Disaster

Business Insider,

17 March, 2012

The economy seems to be doing fine. Central banks in Europe, Japan, and the US are being accommodative. Banks have passed the latest round of stress tests. What could go wrong?

The market doesn't seem worried by anything, which is why, according to BofA's Ralph Axel, it's time to go long on volatility as a hedge against a tail risk disaster. It's not that a disaster is likely, it's just that this insurance is extraordinarily cheap right now.

This chart of the VIX (an index that measures the cost of such downside hedges) indicates that it's super-cheap.

Axel writes:

The VIX, a measure of implied volatility of the S&P 500, is also near historical lows. At 15.8 (as of Wednesday afternoon) it is a point above its low of 14.6 going back to the beginning of 2008. The VIX fell to these levels 3 times since the beginning of 2008: in August (before the crisis of September 2008), in April 2010 (before the first euro sovereign crisis), and in May 2011 (before the US debt limit crisis and second euro crisis; see chart). We do not mean to imply that the VIX is signaling a crisis, but we do mean to point out that options are cheap. 

And history tells us that if one is interested in hedging tail risks, the best time to buy is not in the midst of a crisis or a strong recovery, but at times like now when the market is lulled into a belief that the future holds neither large upside nor large downside shocks. 

He also notes that the same lack of volatility is seen in options on US Treasuries... there's still a general belief that the market isn't going anywhere.

Furthermore, history suggests that a surge in equities (like what we've seen so far in Q1) will be followed by both a rise in yields, and a rise in volatility.

This table shows that going back over the last decade, quarters which saw a rise in stocks tended to see a decline in yields and the VIX, but that in subsequent quarters, 10-year yields tended to jump, and the VIX arrested its fall.

Again, bottom line is that complacency on rates and volatility is probably not warranted.