Risk Investment Team Update

Who are we?
The Risk Investment Team (RIT) consists of 50 students of the University of Groningen. All students have a profound interest in the practice of investing. The RIT is composed of two investment teams, of which one junior team and a slightly more advanced senior team. The teams meet once every three weeks to discuss the performance of their investment portfolios, to review macroeconomic trends and to pitch new investment proposals. After each meeting we have a beer at the bar with our fellow investors.

In this week’s article of the Risk Magazine we briefly review the tense sentiment in financial markets and disclose one of our current portfolio holdings.

Investors fear a rising-rate environment
The latest US jobs report showed the fastest rise in hourly wage growth since the financial crisis. This report has been the trigger of the large sell-off that knocked stocks down 10% from the peak in 2018 and dragged indices into correction territory for the first time in two years. At first sight the job report is positive because it signals economic growth. However, from the perspective of equity investors the report raises the expectation of higher future inflation. This in turn raises the likelihood that the Federal Reserve will respond. Investors fear the Fed will hike rates more aggressively than previously anticipated. The main threat this creates for equities are long-dormant inflation spikes. Therefore, the majority of investors pay close attention to the release of the Consumer Price Index (CPI). The January CPI index turned out to be 2.1% higher year-on-year. The US 10-year yield increased 290% after the CPI was hotter-than-expected. At its February meeting, the Fed announced that it expects to raise rates three times in 2018. Despite this announcement market participants believe there might even be a fourth hike. Hence interest rates, which are already on the rise, might go up at an accelerated rate. Two-year yields are now back at the highest level of the economic cycle. Additionally, as financial stress spikes, the yield curve flattens.

In the presence of higher interest rates, investors require higher expected returns on equities.

Why are investors afraid of fast rising interest rates? In the presence of higher interest rates, investors require higher expected returns on equities. Investors do so because the yield on bonds increase, which implies investors now have an alternative investment vehicle. In other words, bonds become more attractive relative to equities. A higher yield also makes it more attractive to save, or likewise, invest in risk-free government bonds. These are all motives to turn away from relative risky equities. 

Our investment portfolio
Since the meeting of the 8th of January, we incurred a loss of 5,8% on our investment portfolio. In the graph below you can see the sector distribution of our portfolio. Although our portfolio is well diversified sector-wise, we clearly have not been able to withstand the global drop in stock markets. We did not anticipate a large correction and thus failed to include an appropriate hedge position in our portfolio. An appropriate hedge would have been a position in Flow Traders, which increased by 30% during the correction period. To see why Flow Traders would have been an interesting hedge position, see our earlier Investment Team Update (click here). However, most often at times like this cash really is king, even if it is a low-return investment.

Time to lock in fat option premiums
As described above, the uncertainty around the interest hikes, causes an increase in the volatility of equities and therefore also the risk that they entail. This generally results in lower stock prices and higher option prices as investors demand options to protect their portfolio in times of uncertainty. For example, an investor considers buying put options to ensure that its stock portfolio can be sold for a specific price at a certain future date. The investor is then protected against a fall in stock prices. Note that, because it is an option, the investor is not obliged to sell at this price.

Many investors also consider implied volatility as a good indicator of market sentiment.

More activity in option markets can signal that investors anticipate a potential correction in stock prices.  Because of anticipatory positioning of investors, it can be very informative to look at option prices.  In doing so, market participants often look at implied volatility. In fact, implied volatility represents a trader’s view of expected future volatility. Many investors also consider implied volatility as a good indicator of market sentiment. Implied volatility is measured on the basis of actual traded option prices. It is also a key component of the well-known Black Scholes formula - the most commonly applied formula in option pricing.

From the above we conclude that high volatility in financial markets results in high option prices. Since the volatility is implied from option prices, we can also say that implied volatility is positively related to the option price. This holds for any type of option.

ING is market leader in retail- and wholesale banking in the Benelux, which makes ING in our view a very solid company. We also think that ING has an attractive valuation. Unlike most other stocks, banks are likely to benefit from an increase in the interest rate as the banking sector's profitability increases with interest rate hikes. Institutions in the banking sector such as retail banks, commercial banks, investment banks, insurance companies and brokerages have massive cash holdings due to customer balances and business activities. Increases in the interest rate directly increase the yield on this cash and the proceeds go directly to earnings.

In other words, ING profits from the marginal difference between the yield they generate with cash invested in short-term notes and the interest they pay out to customers. Moreover, since economic growth is strong and bond yields are on the rise we are in an environment where consumer and businesses demand for loans increases. This is another source of profitability for a bank like ING.

The implied volatility of ING is presented by the black line in the graph below. As you can see, the implied volatility increased significantly during the correction period. In this graph the AEX index is included to represent the large correction of indices (red line). Note the sharp adverse movement of implied volatility and stock prices (AEX index) in the graph.

During our last meeting, February 12th, implied volatility for options on ING has not been as high since April last year. This does not come as a surprise since stock markets where doing incredibly well over this period. Low interest rates, strong economic growth, sound company earnings reports and low volatility set the major stock market averages on new records almost daily.

However, times are changing. Volatility is definitely back in the market. That is, options are becoming more expensive. This is exactly why speculative investors find it interesting to act on the short side of the option contract. By doing so, investors collect the option price, also referred to as the premium. This price is paid by the party that enters a long position in the option contract.

Acting on the short side of an option contract is exactly what the derivative group of our Investment Team proposed. We agreed to short a put option contract on the ING stock price with a strike price of € 14, thereby locking in an option premium of € 0,42. Note that each contract is on 100 shares of the underlying ING stock.  In return we run the risk of a further drop in the stock price of ING. This means that we start to lose money when the stock price is below € 14 at maturity of the contract. The stock of ING is currently trading at €14,75.  The break-even level is reached when the stock price trades at € 13,58. The payoff structure is presented graphically below.

The total exposure of this position amounts to €1400, which will be lost if the stock price goes to zero. However, we believe that the stock price of ING is more likely to go up. We expect that the correction will come to an end soon and stock prices will partially recover. Although this implies we could have picked any stock option to short, we are more interested in ING as it might be positively affected by an increasing interest rate.

Joining the Investment Team
Are you interested in the Investment Team after reading this article? More information can be found here. In case you are interested or have further questions, please contact us via our email: rit@riskgroningen.nl