Asia Unhedged remains an unabashed China bull. Our logic is simple: If you are a big global equities manager, are you going to buy the MSCI Global Index at a price-earnings multiple of 20, or the Hang Seng China Enterprises Index at a multiple of 10.7 (as of today’s close)? China’s economy might be growing at 7%, or 6%, or 5%, but it is unquestionably growing, while the US economy will probably show zero growth during the first half and Europe and Japan struggle to grow at all.
Option markets tell us something important: buyers of S&P options pay extra for downside protection while buyers of options on Chinese stocks pay extra for upside advantage.
China, to be sure, looks a lot riskier than the US, if we look at the cost of near-term, at-the-money options on the S&P 500 vs. FXI, the popular big-cap China ETF.
Volatility on the FXI (traded on the Chicago Board of Options Exchange in a separate contract, the VXFXI index) always has been higher than that of the S&P 500, as measured by the VIX volatility index. Starting in April, though, Chinese volatility took a big jump and continues to trade north of 30%, about double the 15% implied volatility of the S&P 500. There are lots of good reasons for China to look riskier than the US. In China’s imperial system of governance, policy depends upon one man–Xi Jinping–and his immediate circle, without the checks and balances that moderate policy-making in the US. Chinese standards of corporate governance are behind those of the West (although the subprime scandal of 2008 showed that the West is far from perfect). And China’s stock market is trying to shake an addiction to leverage that adds to volatility.
If we dig deeper into the numbers, though, we see a noteworthy difference between Chinese and American option pricing. The VIX and FXI volatiity rate shown above reflect the prices of at-the-money options (options with a strike price identical to the present market price). But the cost of options (or “implied volatility,” which normalizes options pricing across strike prices and expiration dates) varies considerably depending on your strike price. If you want to buy put options on the S&P 500 at a lower price for downside protection, you pay extra. That’s called the option pricing “skew.”
S&P options 4% out of the money trade at an implied volatility of 15%, while S&P options 3% in the money trade at an 11% implied volatility. In plain English, that menas it costs almost half again as much to buy protection against downside than it does to bet on a significant move up in the index. That big pricing difference suggests that American investors are much more concerned about a big move down than they are about missing out on a big move up.
The exact opposite is true in the case of FXI.
Options buyers in FXI are paying up for upside opportunity, but don’t pay extra for downside protection.
Asia Unhedged is not an uncritical admirer of China’s authorities by any means, but we think that Beijing is doing the right sort of thing, by way of structural reforms and (long overdue) central bank easing. There aren’t a lot of stock markets in the world with real upside, but China is one of them, and the only very big one.