Koch markets first volatility swap

While neither party would reveal the size or direction of the deal, the trade is essentially a swap based on the spread between Nymex WTI and heating oil volatility for January contracts. “The customer had a good view on the volatility of heating oil versus WTI, so we executed two transactions,” said Ilia Bouchouev, executive vice-president and head of energy derivatives structured products for Koch. “In a sense it is a volatility swap spread.”

The new volatility product is aimed primarily at hedge funds, which, according to Bouchouev, are not staffed sufficiently to engage in the continuous and complex delta hedging required to create a robust volatility swap. “If a customer has a view on volatility, he wants to trade volatility, not a portfolio of options,” says Bouchouev. “Therefore we have created a simplified product whereby we take care of the options portfolio behind the swap.”

According to Bouchouev, this gives Koch a hidden way to trade more options and increase its market share in the energy options business. “The hedge fund will trade a volatility swap, but for us each volatility swap will give us the need to create a new portfolio of options,” he says.

The new product is intended to be month- or event-specific; for example, hedge funds may wish to buy or sell volatility just before an OPEC meeting.

While Koch itself has views on volatility movements, the company is initially offering this new instrument in either direction. “We have gone as a market maker. I think we would have struggled to find someone to go in an opposite direction to us, especially with a new instrument. They would have thought we just came up with a new product to make money off them,” he said. For that reason, Koch has hedged itself against the trade and will neither win nor lose. “It will cost us an execution cost, but we hope to regain that through our market making activities,” said Bouchouev. “In time, we may speculate – we always have a point of view on volatility.”

A full story on volatility swaps will be published in Energy Risk (formerly Energy & Power Risk Management) in November.