From the Desk of Risk: Demand for Downside Protection Falls off a Cliff
Equities are at an all-time high and the demand for protection of downside risk has collapsed.
The Credit Suisse Fear Barometer (CSFB) is a measure of the protection that can be purchased through 3-month put options by selling 10% out-of-the-money (OTM) 3-month call options. For example, if put options and call options were equally priced for equivalent levels of money-ness, then the proceeds from selling a 10% OTM call could be used to purchase a 10% OTM put. As the demand for hedging downside risk increases, the cost of the puts will increase relative to the calls. When this happens, the proceeds from selling a 10% OTM call may only be able to purchase further OTM put options (e.g. 20% OTM).
What we have seen with the CSFB index for most of this year has been a relatively extreme demand for downside protection. As a case-in-point, the CSFB hit an all-time high of 35.24on March 26, 2013. What this meant is that – at that date – selling a 10% OTM would only be able to finance a put that was 35.24% below the current SPX level! In fact, during 2013, this index has averaged 31.05 when its long-term historical average has been 17.47.
But we have witnessed a notable break during the past two weeks.This is illustrated in the chart below showing the S&P 500 and CSFB indices. The relative demand for downside protection has collapsed. As we can see from the below graphic, the indices have typically been strongly correlated. When the S&P 500 index has fallen sufficiently hard so that it’s been perceived to reach a bottom, the relative demand for purchasing downside protection also declines. As the market has recovered, the relative demand for downside protection has typically risen as those taking risk incrementally choose to hedge their unrealized gains.
But in the past two weeks, this relationship has broken down. As equities have maintained their relentless ascent, the relative demand for buying loss protection has declined. Is this the face of quantitative exhaustion (read complacency)?
A glance at a longer history may provide a more complete picture. What we see from the below graphic is that the demand for downside protection can be low for two reasons: either the market has fallen so far that the consensus view is that it is near the bottom, or that the market has reached such a state of complacency that downside hedging programs are cut back. What we know with certainty is that markets are at all-time highs and that the relative demand for hedging downside risk has fallen off a cliff. What we do see, however, is that even though the CSFB index has fallen dramatically in the past two weeks, it is nowhere near the lows reached during times of prior market tops. That said, we should keep our eye on the relative demand for downside hedging as this rally stretches into its fifth year.
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