Cost of Hedging Weekly Update 7-9-13

by Jay Pestrichelli on July 10th, 2013

The market rebound from the short-term low on June 24th has been steadily lowering the cost of hedging. As of the close of business on the 9th the short-term daily cost was 0.93 basis points and the mid-term cost out to January rose to 1.01 basis points per day.  
See data for the past 24 months on our Resources Page

Not a lot to say here except that the cost of hedging is following the markets as expected. The last 2 weeks of market recovery has pushed volatility back down in the 14’s and the cost of hedging is bounding around the 1.00 basis points per day. As a reminder, historically, this is a pretty low mark and despite the March and April lows, it still makes sense to use puts as protection here vs. selling to lock in gains.
The story in general remains that interest rates are driving all financial markets. This means that we should expect a higher cost of hedging and a little separation from the VIX.  This is because the Greek Rho will start to have some impact to the value of option premiums.

Investopedia defines Rho as follows: The rate at which the price of a derivative changes relative to a change in the risk-free rate of interest. Rho measures the sensitivity of an option or options portfolio to a change in interest rate.

For example, if an option or options portfolio has a rho of 12.124, then for every percentage-point increase in interest rates, the value of the option increases 12.124%.

We haven’t talked about Rho for the past two years because interest rates have had little prospect of changing. However, with the discussion of tapering from the Fed, we should expect some increase in option premiums. That translates into an increase in the cost of hedging down the road.

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