HOUSE_OVERSIGHT_014772.jpg

Cheapest tail-risk Hedges Adarsh Sinha Ralph Axel Merrill Lynch (Hong Kong) MLPF&S adarsh.sinha@baml.com ralph.axel@baml.com Gabriele Foa Tony Morriss MLI (UK) Merrill Lynch (Australia) gabriele.foa@baml.com tony.morriss@baml.com Shuichi Ohsaki Merrill Lynch (Japan) shuichi.ohsaki@baml.com Tail-risk Hedges ¢ Four tail risks for 2017: 1) US deregulation, 2) EZ risk premia rises; 3) weaker bulk commodity prices; 4) steeper and more volatile yield curve in Japan. ¢ Position for normalization of swap spreads; 30s50s BTP flattener; long EUR/HUF vol; long AUD/USD digital puts; 1y10s20s conditional bear steepener in Japan. There are three key lessons on tail risks from 2016: 1) tail-risk probabilities are generally “fatter” than commonly assumed (Brexit and Trump’s victory); 2} hedging tail risks even in a world of low implied volatilies is hard if the directional implications are unclear (equity puts for a Trump victory); 3) investors worry about tail risks closer to the events — Chart 72 shows the biggest perceived tail risks, according to our Fund Manager Survey, were either during the event itself (China recession worries alongside capital outflows) or at most a few months in advance (Brexit and the US election). Looking ahead to 2017, we believe tail-risk hedging will be more important than ever, but that investors should be sufficiently forward looking and focus on those where there is clarity about the directional implications. We highlight four such opportunities in this section, specifically: 1) US deregulation; 2) return of Euro zone risk premia; 3) China- linked commodity prices weakening sharply; and 4) Japan’s yield curve targeting triggering a steeper curve and volatility increase. Chart 72: Biggest tail-risk, percentage of respondents in Global Fund Manager Survey Oct-16 EU disintegration F Neat] piel Sep-16 Republican wins White House Global FMS biggest “tail risk Aug-16 Republican wins White House (past 12 months) Jul-16 Republican wins White House Jun-16 | Brexit May-16 Brexit Apr-16 Quantitative Failure Mar-16 | Quantitative Failure Feb-16 US recession Jan-16 China recession Dec-15 China recession Nov-15 China recession Oct-15 China recession 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% Source: BofA Merrill Lynch Global Research Tail risk 1: US deregulation Normalized swap spreads, cross-currency basis & coupon vs principal STRIPS Deregulation is a key focus for the incoming administration, and Dodd-Frank is a major potential target. Paul Atkins, a former SEC commissioner under George W Bush, has been named to lead transition strategy on financial regulation. Atkins has been vehemently critical of Dodd-Frank since its inception, and in a statement to the Senate 42 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 Bankof America Merrill Lynch HOUSE_OVERSIGHT_014772