Using Derivatives to Manage Volatile Markets

• Exchange-traded derivative contracts linked to indexes such as the MSCI Emerging Markets, MSCI World and MSCI EAFE Indexes experienced substantial growth during extreme market volatility in March 2020.
• Comparing March 2020 to March 2019, volumes on futures and options linked to the MSCI Emerging Markets Index were up 78%, those linked to the MSCI World Index rose 151% and those linked to the MSCI EAFE Index were up 143%.
• While the premium of outright constant-delta put options rose with market volatility, we show the premium of put-spread collars had less sensitivity to volatility. Option volumes linked to MSCI indexes grew 14% in Q1 2020 vs. Q1 2019.

The accelerated speed of the market declines and unprecedented bouts of volatility experienced in the first quarter of 2020 was a stark reminder that the returns of global and regional equity benchmarks, such as the MSCI World Index, are made up of two risk exposures: local equity-market risk and currency risk (from the non-base currency).

In our previous blog posts, we have examined how multicountry multicurrency futures linked to indexes such as the MSCI World Index, MSCI EAFE Index and the MSCI Emerging Markets (EM) Index have been used to try to manage both the equity and currency exposure of global portfolios. More recently, we explained how the number of contracts, such as those for the EM index’s futures, had grown significantly and had been a consideration in managing EM exposure during both normal and stressed markets.

Now, facing a real-world stress test, how did investors use these tools? Did we see spikes in volumes and open interest in multicountry multicurrency futures? How did the options market react? How have the implied volatilities and option premiums linked to the underlying multicountry multicurrency indexes changed?

Multicountry Multicurrency Derivatives Gained Interest in Challenging Markets

The extreme levels of equity volatility, coupled with high correlations between stocks, may have led to an increased use of futures, as evidenced by increased volumes in specific contracts. We observed that exchange-traded derivative contracts linked to indexes such as the MSCI Emerging Markets, MSCI World and MSCI EAFE Indexes experienced substantial growth during the most intense periods of market volatility in March 2020.

Comparing March 2020 to March 2019, volumes of futures and options linked to the MSCI Emerging Markets Index were up 78%, those linked to the MSCI World Index were up 151% and those linked to the MSCI EAFE Index were up 143%. (Additionally, open interest in futures linked to the MSCI World Index, was up 44% in Q1 2020 in comparison to Q1 2019.) These numbers eclipsed sizable growth in Europe and EM-Asia contracts. One reason for increased volumes might have been the investors seeking to hedge exposure to China or broader Asian equities during the coronavirus outbreak.

Increased Use of Futures and Options over Q1 2020

Did We See Specific Patterns Relating Volumes and Index Returns?

We analyzed the volumes of futures linked to the MSCI Emerging Markets Index traded on the Intercontinental Exchange (ICE) and their relationship to the daily returns registered during the most intense periods of volatility over the first quarter.

Cboe Emerging Markets ETF Volatility Index Levels

Sample period: March 16, 2011, to March 31, 2020. Source: Cboe

As seen in the exhibit above, on Feb. 24, 2020, the Cboe Emerging Markets ETF Volatility Index (VXEEM) — a barometer of risk measured from short-dated volatility in iShares MSCI Emerging Markets Index (EEM) ETF options — stood at 24.9. As the crisis unfolded, VXEEM reached an intraday peak at an eye-watering 192.5 on March 16, 2020.

While that was occurring, volumes in the MSCI Emerging Markets Index futures scaled quadratically with its returns, between Feb. 24 and March 31, 2020. This increase suggests investors may have potentially used these instruments to seek to manage risk, for hedging and/or to take tactical positions during the most stressed market conditions. Note this volatile period also coincided with activity around investors rolling contracts from March 2020 to June 2020, which may also explain part of the volume increases.

MSCI EM Index Futures’ Volume Had a Quadratic Relationship with Futures' Returns

Sample period: Feb. 24, 2020, to March 31, 2020. Source: CQG

Asymmetric Hedging with MSCI EM and MSCI EAFE Index Options

While index futures may have helped manage equity exposures in a linear manner, index-option overlays may have provided an asymmetric payoff — for example, offering downside protection while retaining upside potential. Options linked to the MSCI EAFE and MSCI Emerging Markets Indexes are sometimes used to manage international-equity exposure, mitigate portfolio risk and/or generate additional income from options premium. Options linked to the MSCI EAFE Index and the MSCI Emerging Markets Index had large notional size, approximately 25 to 30 times the size of options linked to two ETFs linked to the same indexes. How have these contracts reacted during the recent crisis? How has the profile of traditional option-based hedging strategies changed?

The recent heightened-volatility environment significantly increased the premium of some outright options. In this section, we run a short comparison between the pricing of puts, put spreads and put-spread collar option strategies linked to the MXEF index.

The time series of the premium for each strategy is shown below as a percentage of the spot price of the MSCI EM Index. The exhibit below illustrates how the cost of protection for an outright constant-delta put rose significantly since the onset of the COVID-19 crisis, as implied volatility reset to a higher level. The strike price for the same delta option was also lower. Hedgers faced significantly higher premiums if they sought to protect their portfolios using outright options. Spread-based option strategies helped mitigate some of the upfront premium (the trade-off was potentially less protection).

MSCI EM Index Options: 12-Month Hedging Premium

Sample period: May 4, 2015, to March 31, 2020. Source: OptionMetrics

The time series of the strike prices implied by each of the constant-maturity options are shown below, also as a percentage of the spot price of the MSCI EM Index. As we can see in the exhibit, the sale of deeper-out-of-the-money (OTM) puts and OTM calls generally widened the downside-protection levels and upside potential in put spreads and put-spread collars in the recent environment.

MSCI EM Index Options: 12-Month Strike Prices

Sample period: May 4, 2015, to March 31, 2020. Source: OptionMetrics

The final exhibit below shows the ratio of the one-month implied volatility over the 12-month implied volatility of options linked to the MSCI EM Index. Over the period, we saw an inversion in the term structure of implied volatility. In such an environment, some tactical investors with a shorter-term view have, at times, considered shorting shorter-dated calls or puts that were priced higher in terms of implied volatility, as they sought to generate premium and fund longer-term hedges.

MSCI EM Index Options: Ratio of 30-Day to One-Year At-the-Money Implied Volatility

Sample period: May 4, 2015, to March 31, 2020. Source: OptionMetrics

Using Derivatives in Challenging Times

Broad-based multicountry multicurrency derivatives saw a sharp increase in volumes and open interest during the challenging market conditions of the first quarter. Sourcing liquidity when it is needed can be vital for equity investors, and these instruments may have been used to manage equity and foreign-currency exposures. Hedgers using outright put options paid materially higher premium in Q1 2020 compared to recent years to protect their portfolios. Alternative hedging approaches such as put-spread collars have been less sensitive to changes in volatility, but have had the added risk of less tail-risk protection and lower upside participation.

¹We compare March 2020 to March 2019, because investors often roll their exposure at quarter-end to the June contract.

²Futures and options linked to an MSCI index are not MSCI products; MSCI indexes are used only for product construction and price referencing.

³The most popular index-hedging overlay is simply buying a put option defined to pay off below a reference index level (the “strike price”), and nothing otherwise. Some more popular alternatives to outright put options are put spreads (partial protection between a range of index values) and put-spread collars (put spreads with limited upside potential).

Further Reading

Using multi-country multi-currency futures in portfolio management

Looking to the futures of emerging markets

Asset allocation and index futures during market crisis