Highlights of the Week
• Market: The market continued to suffer from the loss of momentum, as the
prevailing sentiment appears to be that the stellar performance since mid-March
is unlikely to be sustained. In the background were the rising Yen, and the
precipitous decline in the Chinese equity market, where the Shanghai
Composite had fallen almost 20% since the beginning of August. The market,
however, does not seem to believe a major correction is in the making―the
Nikkei short-dated implied volatility still trades at the pre-Lehman Shock levels.
The average price-to-book ratio suggests that equities are priced attractively, and
provided that the economy remains in its recovery track, we believe that the
market will resume its upward trajectory. In this regard, September may serve as
the key month, at whose doorstep the upcoming Lower House election (Aug 30)
ominously rests. We expect higher volatility in the coming months.
• Pair-trade performance: Utilizing our Daily Pair-trade Monitor, we have
periodically published reports recommending specific pair-trade ideas (most
recently on Aug 20―Long Hakuhodo/Short Dentsu: Long Mizuho Trust/Short
Sumitomo Trust). In one of our earlier reports (Equity Derivatives Review –
Power of pairs, November 10, 2008), we examined the performance of
recommended pairs. Of the 13 pairs recommended, 12 recorded positive returns,
with the average return of 3.55%. This week, we look at the pairs recommended
since that time.
• Trading correlation through single stocks: Traditionally, correlations are
traded through dispersion trades―pair-trades between index variance and
average (weighted) single-stock variance of the index constituents. As
correlation exhibits a mean-reverting characteristic (usually between 0.6 and 0.2
for realized correlation) and is often inversely correlated with the market, it is
also of great interest among non-option investors. We have shown in the past
(Equity Derivatives Review – Predictive power of volatility and correlation,
April 3, 2009) that correlation can be used to trade index futures, or put another
way, although not in the most strict sense, index futures can be used to trade
market correlation. In this report, we suggest a methodology to trade correlation
through single stocks.