If you’re a raging bull on equities you’d be a fool not to consider some exposure to the higher growth region of Asia. And as a raging bull on equities in 2011 Goldman Sachs has laid out their favorite trades for Asia in the coming year:
1. Our three favorite markets for 2011 are the lowest vol markets globally. KOSPI 200, TWSE, and MSCI Singapore are three of the lowest implied vol markets in the world. On each of these three markets, owning 6-mo 110% upside calls costs less than 2% and is a reasonably easy way to put on long exposure with limited risk. While we have often suggested long AEJ vs. short DM trades, our more positive DM view makes us prefer the simplicity of simply using calls for exposure. Currently 6-mo 110% calls cost 1.75%, 1.71%, and 1.25% on KOSPI2, TWSE, and MSCI Singapore, respectively. Risk is loss of premium.
2. HSCEI vs. SPX 1-year variance is our favorite China inflation hedge, but NKY vs. SPX 1-year variance also carries very well. We believe the three ingredients to a strong derivative trade are (1) A good fundamental story; (2) An attractive entry point; and (3) Historical profitability. The HSCEI vs. SPX 1-year variance trade satisfies all three criteria, as we discussed Thursday in our piece China inflation hedge with positive carry: HSCEI vs. SPX variance. The Nikkei 225 vs. S&P 500 1-year variance pair satisfies two of the three factors, given historical profitability and an attractive entry point, though we have less of a fundamental case relative to the HSCEI vs. SPX pair. Sellers of variance swap risk unlimited loss at expiry;
buyer of variance swaps risk losing var strike^2 / (2 * var strike) at expiry.
3. HSCEI and oil correlations have begun to decline with oil prices moving lower and HSCEI moving higher. Two of our macro views for 2011 are high commodity prices and muted returns for emerging markets. On this note, it is interesting to see HSCEI and WTI have begun to de-correlate. Given our view that inflation is a problem for China, the correlation could remain low. Owning puts on HSCEI contingent on oil prices higher plays into this trend. Current 3-mo ATM puts on HSCEI contingent on WTI up 10% cost 1.2%, a 80% discount to ATM vanilla puts. Risk is loss of premium.
4. NKY calls are an inexpensive way to play our global strategists’ top trade to go long Japan. Following this year’s underperformance, we expect NKY to display beta to the improving global industrial cycle. Nikkei calls remain half a standard deviation below their one-year average, and have recently been a profitable way to gain market exposure while keeping risk limited in the case of Japan equities disappointing. For exposure through the Japan fiscal year, NKY Apr-11 105% calls cost just 2.6%. For exposure to our Japan over China view, selling 3-mo 105-115% call spreads on HSCEI fully funds 3-mo NKY 105% calls (Ex 4). Risk is loss of premium.
5. NIFTY puts remain inexpensive and are a preferred hedge. We continue to see NIFTY puts as attractive hedges. The market is expensive in our view, earnings have been revised down for six months in a row, there has been a lot of foreign inflow, and probes by the CBI create additional uncertainty. Feb-10 95% puts cost 1.7%, which we find inexpensive in light of the risks we highlighted in our 2011 Outlook. Risk is loss of premium.
6. Forwards create opportunities. The TWSE vs. NIFTY forward differential provides a “head-start” via divergent strikes for a call vs. call pair trade. Our analysis shows that forwards have very little correlation with future returns. As such, the 10-point differential between the TWSE and NIFTY forwards is an attractive starting point for buyers of TWSE calls and sellers of NIFTY calls. Currently, selling 1-year 115% calls on NIFTY fully funds 1-year 105% calls on TWSE; attractive entry levels in our view for a trade we fundamentally like. Risk is unlimited if NIFTY rises more than 15% and TWSE does not rise more than 5%.
7. Geopolitical risk in Korea? Limited, according to the options market. We believe implied vols remained surprisingly low on KOSPI. Current 3-mo 25-delta put implied vol is just 22 and one of the lowest among major markets globally. While we continue to like Korea fundamentally, short-dated put or put spread hedges appear to be pricing in limited risk following the North Korea tensions, given little rise since the most recent North Korea incident towards the end of November.
Source: Goldman Sachs
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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