Societe Generale Corporate and Investment Banking (SG CIB) has developed a new type of option that allows buyers to specify the level of volatility used to price the instrument. Called a timer call, the product is designed to give investors more flexibility and ensure they do not overpay for an option.
The price of a vanilla call option is determined by the level of implied volatility quoted in the market, as well as maturity and strike price. But the level of implied volatility is often higher than realised volatility, reflecting the uncertainty of future market direction. In simple terms, buyers of vanilla calls often overpay for their options. In fact, having analysed all stocks in the Euro Stoxx 50 index since 2000, SG CIB calculates that 80% of three-month calls that have matured in-the-money were overpriced.
"High implied volatility means call options are often overpriced. In the timer option, the investor only pays the real cost of the call and doesn't suffer from high implied volatility," says Stephane Mattatia, head of the hedge fund engineering team at SG CIB in Paris.
Under the timer call, the buyer can specify an investment horizon and an expected volatility. A variance budget is then calculated (target volatility squared, multiplied by the target maturity), which forms the basis for the option's price. Once the variance budget is consumed, the option expires.
For example, if an investor buys a timer call with a target of three months and believes volatility over this period will be 20, the variance budget would be 0.01 (0.2 x 0.2 x (91.25/365)). Once this is consumed - in other words, once realised volatility squared multiplied by the number of expired days divided by 365 is more than the variance budget - the option would expire.
If the investor is correct and realised volatility is 20, the option will mature in exactly three months. If the realised volatility is lower than expected (say, 15), the option will expire at a later date (around five months). Likewise, if realised volatility is higher (say, 30), the option will expire sooner (around 1.3 months).
SG CIB piloted the product with a small number of hedge fund clients in April, and is now rolling it out more widely to its client base. "The reception has been very positive, and we've already traded on stocks and indexes in Europe and the US, as well as on Asian indexes," says Alastair Beattie, managing director in the hedge fund group at SG CIB in London.
The first trade was at the end of April with a hedge fund client. The fund unwound existing plain vanilla calls on HSBC with a June expiry and rolled them into an HSBC timer call. At the time, the implied volatility on the plain vanilla call was slightly above 15%, but the client set a target volatility level of 12%, a little higher than the prevailing realised volatility level of around 10%.
By rolling into a timer call, the hedge fund reduced its premium by 20%. Since the inception of the trade, the realised volatility has been around 9.5%. If it remains at this level, the maturity of the timer call will be 60% longer than the original vanilla call. SG CIB has now traded on 20 underlyings for a total notional of EUR300 million.
"This product is going to have an application for anyone trading options where they find the implied volatility expensive," says Beattie. "The normal evolution for new products is that hedge funds will be first to move, then it will be picked up by other types of investors. Any sophisticated investor with a view on the volatility of an underlying as well as its price evolution, will be able to use it."