Deteriorating relationships between the U.S. and the People’s Republic of China (PRC) over Taiwanese sovereignty hit a new low today as U.S. Speaker Nancy Pelosi became the highest-ranking U.S. official to visit the island nation in over 25 years.
Pelosi arrived in Taipei, Taiwan’s capital at 11 PM local time on Tuesday, August 2nd, a move heavily criticized by the current PRC administration. The PRC previously warned of «resolute and strong measures» should the trip go ahead, with their ministry of defence vowing to «safeguard national sovereignty» in response to perceived interference by the U.S. in its self-proclaimed sphere of influence.
Military measures are afoot, with reports of PRC fighter jets crossing the Taiwan strait according to Chinese state media, and the U.S. Navy positioning four warships, including an aircraft carrier east of Taiwan. In light of the recent invasion of Ukraine by Russia, tensions continue to run high.
A discussion of how the geopolitical situation is likely to play out is beyond my expertise and scope as a financial writer, but it is worth examining the potential effects on the markets, and more importantly, investment portfolios as a unique form of tail risk.
Political Tail Risk
A particular risk worth addressing here is tail risk, which is defined as a highly improbable loss that occurs three standard deviations left from its current price. Nassim Taleeb called this the «black swan», denoting a catastrophic, unforeseen event with outsized consequences.
Tail risks are often extremely difficult to quantify with conventional methods due to the myriad of qualitative factors that induce them. A notable one is political risk, which is the possibility of loss due to unforeseen volatility occurring in the geopolitical climate of a certain region or between nation-states.
Political risk is not often considered when it comes to risk management, and is often used for speculation in the currency and commodity markets. However, it’s outsized effect on portfolio value cannot be ignored. A pertinent example was what occurred to exchange-traded products (ETPs) holding Russian securities at the onset of the invasion of Ukraine.
Numerous asset managers such as Invesco and BlackRock shuttered Russian equity ETPs, citing their «discretion to terminate the fund if there are changes to the business, economic or political situation that would have material adverse consequences and were against the interests of shareholders». A main reason for this was a lack of liquidity, with BlackRock citing that: «a significant portion of Russian securities are still not currently tradeable for non-Russian foreign investors.»
The effect on investors was disastrous. Numerous funds were liquidated at their net asset value (NAV), which were already at all-time lows due to significant losses in the underlying and investor outflows. Before this, secondary market trading was suspended, preventing investors from triggering stop-losses and exiting their positions.
Hedging with inverse ETPs
Regardless of how the current situation in Taiwan plays out, volatility is likely to surge for the markets of those affected. Investors with long positions in Chinese or Taiwanese equities can consider hedging their positions against the remote, but highly deleterious effects of a potential conflict.
Traditionally, investors utilized put options to hedge against a market crash. The issue with this is that options premiums for puts tend to soar when volatility increases, and thus makes the cost of hedging rather pricey. Investors must also grapple with calculating their delta exposure, selecting the correct strikes, and determining the optimal time to expiry that does not incur excessive time decay (theta).
A better solution that makes position sizing and entering/exiting a position easier is with an allocation to inverse ETPs. These products offer daily leveraged exposure the opposite performance of an underlying basket of equities. The primary benefit of this approach is that with inverse ETPs, the maximum risk of your position is the value you paid for the shares, much like premiums for options.
Unlike options, the price of an inverse ETP is dependant on the daily movements on its underlying. Thus, investors do not have to worry about the effects of theta or changes in implied volatility, all of which can affect an option’s pricing even if the investor predicts the underlying asset’s movements correctly.
Leverage Shares offers the following inverse leveraged ETPs for Taiwan, China, and the U.S. respectively. All ETFs are physically backed and trade in multiple currency denominations (USD, EUR, GBP), mitigating the need for contracts for differences (CFDs) or conversion costs.
