24 November 2016 by lberuti
The European Central Bank warned of the risk of an abrupt market correction on the back of rising political uncertainty and the threat it could pose to banks, stability and economic growth. In their twice yearly Financial Stability Review published this morning, they said “more volatility in the near future and the potential for an abrupt reversal remains significant”. Credit investors appear to agree with that cautious stance, and iTraxx Main (ITXEB) and iTraxx Financials (ITXES) have underperformed other credit indices in the recent past and are stuck at the wides of their recent range. That caution is also apparent in the credit option market. Unlike implied volatility of other assets – equities for instance, but also CDX IG or iTraxx Crossover in credit land – ITXEB’s implied volatility has recently followed a systemic widening pattern, much like in January/February of this year. The increase has been even more pronounced on ITXES’s implied volatility mirroring the underperformance of that index. Volatility surfaces are also characterised by very steep smiles, which means that downside protection (out of the money payers) is more expensive than upside protection (out of the money receivers). So much so that investors who have a sanguine view of the market impact of the next political events and of the ECB meeting on December 8th can enter bullish strategies at attractive levels.