Record levels of volatility in the equity market since September have caused huge losses on popular indexes that allow investors to take short implied volatility positions.
These quantitative strategies aim to capture the premiums for implied volatility over realised volatility by regularly selling variance swaps. This had traditionally been profitable in benign market conditions, with implied volatility typically greater than realised volatility.
Many banks have launched indexes to provide exposure to this strategy, including Barclays Capital, BNP Paribas, Merrill Lynch, Morgan Stanley, Société Générale and UBS. For example, Barclays Capital launched its Voltaire Index in April 2007. Using a systematic allocation algorithm, the strategy tracks four equity indexes - the Dow Jones Eurostoxx 50, the S&P 500, the Nikkei 225 and the FTSE 100 - and each month sells a variance swap on the index with the largest differential between implied and realised volatility.
On a back-tested basis, the strategy produced an average annual return of 47.87% over the period between August 18, 2000 and June 29, 2007.
However, these indexes generate potentially hefty losses when realised volatility rises above implied levels - as has been the case since September.
The Chicago Board Options Exchange's Vix index, which measures the market's expectation of 30-day volatility on S&P 500 index option prices, reached a closing high of 80.86% on November 20. The index has recorded rising levels of volatility since the start of September, when it was at 20.65%, hitting 36.22% on September 17, 46.72% on September 29 and 69.95% on October 10. The Vix closed at 54.92% on November 26.
Meanwhile, the CBOE S&P 500 Realised Volatility Index, which measures three-month volatility of the S&P 500, recorded a high of 92.24% on September 22, having started the month at 21.63%. As of November 25, it stood at 76%.
"These short volatility strategies are most vulnerable during the move to a higher volatility regime," says Aaron Brask, head of equity derivatives research at Barclays Capital in London.
The implied versus realised volatility indexes run by banks have all plunged as a result (see figure 1). Barclays Capital's US dollar-denominated Voltaire Index dropped 96.1% to 43.52 on October 27 from 1,129.59 at the start of September. It had rebounded slightly to 80.36 as of November 25 (see figure 2).
Société Générale's SGI Vol Premium Total Return Index denominated in US dollars fell 30.1% to 745.06 on November 20 after beginning September at 1,065.49. It stood at 754.67 on November 25.
Meanwhile, the euro-denominated Regular E-volution Total Return Index run by BNP Paribas fell 8% to 2.5872 on November 11, compared with 2.8122 at the start of September. It stood at 2.5944 on November 25.
Bertrand Delarue, global head of structuring for equity derivatives at BNP Paribas in Paris, says a wide variety of investors would have been affected by the drop in value of these indexes due to the popularity of the strategy over the past two years.
"Short volatility indexes were included in products sold to retail and high-net-worth investors, typically with principal protection. They were also included in hedge fund strategy replication products sold to pension funds and asset managers," he remarks.
"Sophisticated investors still have some appetite for selling volatility with the expectation it will drop again. But with the high levels of volatility of volatility at the moment, offering principal protection for structured products is very expensive, so these products are not so appealing right now," he adds.
Nonetheless, bankers argue these indexes are not dead, despite the recent losses. In fact, they claim the current high volatility environment may be the perfect opportunity to enter into these strategies.
"As we believe we are at the high end of the volatility spectrum, we expect these strategies to perform very well over the next few quarters and for there to be a strong rebound. However, as with the underlying equity indexes, we do not expect losses to be entirely recovered as volatility is not likely to revert back to its lows in the near term," says Barclays Capital's Brask.
"How quickly the indexes will recover depends on when market confidence improves and levels of volatility fall. The extreme levels of volatility we are experiencing right now are more than capable of collapsing within a short period of time, and when this eventually happens there could be a significant recovery in the levels of these indexes," adds Nick Tranter, European head of equity derivatives flow sales at BNP Paribas in London.
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