We’ve seen volatility at its worst: The Black Monday global market crash of 1987, the Asian financial crisis in 1997, and the global financial crisis that started with subprime mortgages in the US, circa 2008. Periods of such profound market volatility are rare. Day-to-day volatility is often mild and contained, yet it still plays an important role in how profits are won and lost.
A confluence of factors underlie market volatility from earnings reports and political events to central bank announcements and economic indicators. Such factors have made headlines and shaped the market climate over the past year. Case in point: equity volatility in US markets is rising amid monetary tightening by the Federal Reserve, the potential for slower economic growth, and trade tensions between the US and China.
With these factors in mind, investors are turning to an important market tool for guidance as they develop and adjust their trading strategies: the volatility index.
Tapping the fear gauge
The financial industry began using volatility to measure market risk in the wake of the Black Monday crash, giving rise to the CBOE Volatility Index – “the Vix” or Wall Street’s “fear gauge” – in 1993. In effect, the Vix is a crowd-sourcing estimate for the degree to which the market is uncertain about the future, and thus a potential prediction of changes in volatility.
The listing of tradable Vix futures and options in 2004 and 2006, respectively, coupled with the index’s consistent negative correlation with equity markets, has prompted investors to adopt Vix-based instruments to hedge their portfolios against market downturns and to speculate on market turmoil.
The Hang Seng Index (HSI) followed suit in 2011, launching the HSI Volatility Index to gauge expected volatility among investors over the next 30 calendar days. The index has become a closely-watched barometer of sentiment in the Hong Kong stock market. This gave rise to HSI Volatility Index Futures – a tool that enables investors to manage risk in Hong Kong’s stock market, leverage volatility and diversify their portfolios.
Amid increasing foreign investor interest in China’s financial markets, the HSI launched a new volatility gauge dubbed the VHSCEI at the end of 2018. Focused on the Hang Seng China Enterprises Index (HSCEI) – an index that tracks shares of mainland Chinese companies that are traded on the Hong Kong Stock Exchange and thus serves as a proxy for China’s stock market – the VHSCEI reflects the index’s 30-day expected volatility.
According to the historical performance, the VHSCEI reached its highest point of 2018 on February 9, the day the HSCEI dropped nearly 4% amid global stock market declines. These and other results demonstrated that the VHSCEI can reflect investor sentiment when the stock market is in turmoil.
Given its inverse correlation with the HSCEI, the VHSCEI presents opportunities to develop investment products including futures, ETFs and ETNs to manage volatility exposure for a range of HSCEI-linked products. In short, they could serve as a hedge against investments that use the HSCEI as a benchmark.
A compass for market uncertainty
Just two weeks into 2019, China doubled the foreign investment limit for one of the main channels through which overseas investors access its stock and bond markets to $300bn. People’s Bank of China later pledged to further open China’s bond market to foreign investors in coming years.
While Chinese authorities liberalize the country’s financial markets in measured steps, allowing increased foreign participation could stoke volatility. Over the past few decades, several emerging economies including Indonesia, Thailand and Mexico suffered major financial crises after drastic financial liberalization.
Regardless of whether financial liberalization proves a boon or a bane for Chinese markets, doomsayers say that China’s $34trn pile of public and private debt is a threat to the global economy, despite efforts that target risks in the country’s financial system.
For many, choosing not to invest in China could be the greater risk, given the incredible potential that the country’s investment opportunities offer.
Against this backdrop, the VHSCEI is the tool that China-focused investors need – a compass to guide them through waters that are rich with potential but rife with uncertainty.
Learn more about the HSCEI Volatility Index here.
