The year 2017 saw the juxtaposition of heightened policy uncertainty with relatively complacent markets and low volatility, especially in equities. Much of the policy uncertainty may find some answers in 2018. It is decision time for NAFTA and Brexit. Elections will be in the spotlight, too. Italy in March, Mexico in July, Brazil in October, and November 2018 will see a ferociously contested US election for the entire House of Representatives and one-third of the Senate. At the Federal Reserve (Fed), the focus will be on inflation and the shape of the yield curve as it decides how aggressively to push rates higher or not. The weather will play a role, too, as we find out if La Niña deepens and brings droughts to Brazil and Argentina or fades away quietly.
Event risk can present some interesting risk management challenges. The two possible outcomes are typically binary in nature, like an on/off switch. Before the event, markets may price an average of the two vastly different outcomes in terms of their impact on selected products or securities. After the event, the market’s ‘average’ of the two outcomes will definitely not survive the outcome, as markets move quickly to price the actual outcome as it becomes known. In these types of market environment, options can be a favored risk management tool. In addition, if the probability of a price break or gap is substantial around the time the outcome becomes known, the options prices will add a premium for price gap expectations in addition to the typical estimate of future volatility. This means that implied volatility calculations using models that assume price gaps/breaks do not exist (i.e., basic Black-Scholes-Merton) may over-estimate volatility by the amount of the potential price break premium.