Global | Politics & Geopolitics
Policy uncertainty is everywhere. Trump’s trade policy, Brexit, and the rise of populism. All have played a significant part in its rise. The challenge for investors is how to measure this type of uncertainty. One popular approach has been to track media coverage deploying key phrases such as ‘economic uncertainty’. The Economic Policy Uncertainty (EPU) index uses this approach. It covers a range of countries including several developing economies and is freely available. Generally speaking, the EPU is correlated with equity volatility and the business cycle as one would expect.
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Policy uncertainty is everywhere. Trump’s trade policy, Brexit, and the rise of populism. All have played a significant part in its rise. The challenge for investors is how to measure this type of uncertainty. One popular approach has been to track media coverage deploying key phrases such as ‘economic uncertainty’. The Economic Policy Uncertainty (EPU) index uses this approach. It covers a range of countries including several developing economies and is freely available. Generally speaking, the EPU is correlated with equity volatility and the business cycle as one would expect.
The trouble is that the EPU is only available monthly and may not necessarily use comparable news sources across countries. Enter new work from Central Bank of Brazil researchers, Jose Vicente and Jaqueline Marins. They have developed a new ‘Volatility Smile-Based Uncertainty’ index (or the VSU index for short). It uses market prices to determine uncertainty. That way, the index can be calculated in real-time and is more consistent when comparing across countries. But how effective is it?
What is the Volatility Smile (VS)?
The researchers take advantage of information contained in FX options market, notably the volatility smile. In most markets, the expected (or implied) volatility of a currency varies depending on how far you project the currency (strike price) to be from current levels. Often the implied volatility is higher the further away the projected rate is. In the options world, this is known as the volatility smile (see chart – the lowest point, or bottom of the smile, is around current spot levels; the further away you go on either side, the higher expected volatility is).
How Do They Construct the VSU Index?
Armed with the volatility smile, the researchers take the implied volatilities along various points of the smile. More precisely, they look at 10, 15, 25, 35, and 50 delta strikes for calls and puts for one-month options in a given currency pair. They then sum the magnitudes of the gap between these implied volatilities and a neutral level of volatility (a model-free measure). In essence, the happier the smile, the more uncertainty is expected in options markets.
They calculate VSU indices for Brazil, India, Mexico, Russia, and Chile using dollar exchange rates for each market. The indices are shown in Figure 1. It can be seen that the index does capture key uncertain periods. For example, clearly visible is a correlation with the collapse in oil prices that affected Russia in January 2015 and the prolonged period of uncertainty between May 2014 and June 2016 in Brazil during the impeachment period for President Dilma Rouseff.
How Does VSU Compare With EPU?
One would expect the VSU and EPU indices to be correlated with each other since they both capture policy uncertainty. Indeed, for the five countries featured, they are. Interestingly, the EPU measure is more volatile than the VSU one. The EPU also appears to exhibit more persistence in its signals.
How Does the VSU Index Relate to Economic Activity and the Stock Market?
Comparing the VSU index to industrial production, they find that the VSU does tend to lead changes in industrial production. The relationship is statistically significant even when lagged versions of industrial production are included. It also appears to have a stronger statistical relationship with industrial production than the EPU does.
Rather than the level of the VSU index, they find that changes in the VSU index are negatively correlated with stock market returns. However, they find that the EPU has a similarly strong relationship too.
Bottom Line
It’s a great idea to extract a measure of uncertainty from FX options markets. The data is more ‘objective’ and is available in real time. The downside is that the measure may not work for several larger markets. For example, which exchange rate would one use for the US? If one takes EUR/USD, then it would also be capturing European uncertainty. Another problematic country would be China – USD/CNY is heavily managed, so the options market may not properly reflect investors’ perceptions of uncertainty. The same could be said for pegged countries like Saudi Arabia.
That said, for most other markets, the VSU approach could provide a useful compliment to existing uncertainty measures such as the EPU.
Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)