Behind the Markets

May 1, 2017 Parke Shissler

Behind the Markets

Twenty years ago, VH1 producers hit upon a winning formula for a music television show. Fans could sing every lyric from their favorite songs without needing album notes, but they might not know the deeply personal vignettes that birthed them. So starting in the summer of 1997, with the tragic tale of Milli Vanilli’s meteoric rise and fall, VH1 began to air its legendary show Behind the Music.

The show’s quick cuts between grainy concert film, timely musical overlays, and intimate interviews with band members and close confidantes made it iconic overnight. Music fans loved the access to “compelling personal stories about the success, tragedy, and triumph” of top stars in the music world. Over scores of episodes, they were captivated by the compelling drama of how M.C. Hammer sold millions of records and then filed for bankruptcy, how Jim Croce promised his wife he’d stop traveling after this last tour but was taken by a plane crash, and how roughly seventy-three different musicians overcame serious drug addiction to achieve the modicum of sobriety required to sing nightly.

Behind the Music went on to inspire numerous parodies and imitations, including what many regard as the greatest Saturday Night Live skit of all time, “More Cowbell.” It also got us thinking – what if we could put together a newsletter to take you behind the markets, to the hidden stories behind the headlines? We took a shot at a couple of storylines for the pilot program; let us know what you think!

Smirking on Friday but Smiling on Monday
In the FX volatility markets, the gap between market participants’ willingness to sell call protection versus selling put protection can be quite material. Even if the FX spot rate itself might not move much, the volatility markets contain considerable information about how traders currently price downside protection. When rate increase and decrease scenarios present roughly equivalent risk, volatility values graphed across a range of strikes show a smile-like shape (the volatility smile), as at-the-money volatility is lowest and rises the further out-of-the-money a call or put strike is set. By contrast, when rate appreciation risk is considerably higher or lower than rate depreciation risk, the shape looks more like a smirk.

To see this in action, compare the EUR-USD 1-week volatility shape taken Friday the 21st (just before the French election) and Monday the 24th (just after it). The smirk on the left contains a great deal of information – absolute volatility levels were quite high, ranging from 17% to 24%, and the market was massively skewed towards downside risk, with a 7-vol gap the highest in a decade (together with the week before Brexit). By contrast, after the French elections yielded an establishment candidate as clear favorite for round two, market sentiment on Monday produced the smile on the right, with a much lower level of absolute volatility ranging from 8% to 10%, and little disparity between put and call insurance. In short, the absolute cost of insurance for appreciation or depreciation fell considerably – the drop of 4.75% in one-month implied vol was the largest single-day fall in history – and the gap between the two kinds of insurance narrowed tremendously.

That Not-So-Surprising Economic News Release
The Wall Street Journal published a note this week comparing how GBP and SEK currency markets move in the hour before and after key economic data releases. Whereas the Swedish krona did not move until the moment of the news release in any predictable direction, the British pound moved noticeably in the direction it would continue moving once the news was released – in fact, half of the total move was already made in advance.

The key takeaway, according to study author Professor Alexander Kurov, is that the “evidence of informed trading before U.K. macroeconomic news is very strong,” whereas there is no similar evidence for Swedish announcements. In Sweden, only the official statistics office is allowed to see sensitive data before it’s released, while in Britain, more than one hundred people find out up to a day in advance. Could it be that the pattern of GBP trading before the data release, which goes in the same direction as trading after and accounts for roughly half of the total news-based move, be based on informed trading?

We never would have known all that Jennifer Lopez or Lil’ Wayne overcame to hit the big time without Behind the Music, and we would never know all the factors that underpin headline financial rate moves without Behind the Markets. If you’d like to see us cover a specific topic in a future edition of Behind the Markets, please give us a call!

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