Implied volatility surge sees the return of institutional hedging

Similar to August last year, the significant increase in global implied volatility levels has put increased pressure on insurance companies to hedge their liabilities using protective option strategies.

Equity index implied volatility levels last month for the FTSE, DAX and S&P 500 were around double the monthly average of the last eight years, and were only around 50 basis points below the levels seen at the end of August last year. The FTSE and DAX saw average implied volatility reach 24% and 31% for June, while the S&P 500 implied volatility stood at 23%. This compares with 17.75%, 18.5% and 14% for June last year, repectively.

“Implied volatility reached four-year lows during March this year. But now short-term volatilities are hitting four-year highs,” said Larry Chen, an equity derivatives analyst at UBS Warburg in London.

The main driver of the increase in the European index volatility was the depression in the equity markets following corporate governance scandals in the US.

“Following September 11 equity index prices rose until March,” said Chen. “Then everything went down - when the cash markets drop,; implied volatility rises.”

Over the last three months, the big European insurance companies and pension funds have increased their use of options to hedge their exposure to equity markets. These institutions have focused on buying puts and executing collar strategies, according to Goldman.

Industry regulators have attempted to reduce the pressure on pension funds and insurance companies by relaxing the rules on portfolio solvency levels. Countries such as the UK and Denmark normally require insurers and pension funds to reduce risk and strengthen capitalisation when certain trigger levels are reached. But a UK ruling passed at the end of June temporarily relaxed the solvency requirements for institutions, enabling them to hold their equity positions for longer.

Despite these measures, implied volatility has continued to rise, said Goldman, with analysts worried that a further equities sell-off could spark further downward pressure on stocks, causing a further increase in volatility.

But some larger institutions are also considering more adventurous strategies by selling equities while simultaneously buying calls in the expectation of a future rise in equity markets. Such strategies would not be immediately observable due to the size of the institutional portfolios and the necessity to get approval from investors, though it could have an effect in the future, said Altaf Kassam, derivatives and trading research analyst at Goldman Sachs, and one of the authors of the report.