Using the VIX to Hedge Against Subprime Fallout

by: Larry MacDonald

On Friday, July 20, fresh concerns over a deepening of the crisis in U.S. subprime mortgages led investors to bid stocks down and government bonds up in a renewed flight to safety. Also, the prospect of the Federal Reserve lowering interest rates in response to the crisis weighed on the US dollar and lifted gold.

The more pessimistic of observers see a self-feeding debt-deflation process unfolding, possibly as serious as the one that triggered the Great Depression of the 1930s. One of the scarier statistics to which they allude is the number of adjustable-rate mortgages resetting this year and next: over $500 billion (U.S.) in 2007 and more than $650 billion (U.S.) in 2008.

Others think the subprime crisis will not have any contagion effects. They argue that periods of financial stress are historically associated with monetary clampdowns and higher borrowing rates. But with inflation subdued, there is minimal risk of central banks tightening and bond yields rising significantly. Furthermore, corporate balance sheets remain in good shape and the buyout artists still have incentives to bid for corporate cash flows given relatively low borrowing rates.

What to do? Market timers, stock pickers, and practitioners of tactical asset allocation might start thinking of hedging. Friday’s action suggests that some places to increase exposure are government bonds and gold.

Late-stage bull markets can have strong gains but volatility typically rises. BCA Research suggests taking out insurance with volatility indexes. For the VIX, this can be done with options or futures contracts. From 1996 to 1998, during the mature phase of the previous bull market, the VIX trended up from 12 to 30.