Spike in equity volatility causes pain

“If the current market environment persists, the negative impact of the accumulated volatility, correlation and dividend risk on the profit and loss of books may become significant,” said Adrian Valenzuela, head of equity derivatives flow marketing at JP Morgan in London.

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, touched 37.5% on August 16, its highest level since October 2002. It traded at above 20% for much of last month, closing at 20.98% on August 25.

It was a similar story in the less liquid long-dated over-the-counter market last month. On August 21, dealers were quoting five-year at-the-money option implied volatility for both the S&P 500 and Euro Stoxx 50 at around 25%.

Some firms have become very short volatility over the past year as investors and insurance companies have bought downside protection. Protection buying has taken the form of vanilla put options and simple barrier options that lower the premium paid by the hedger. A number of hedge funds have also taken long volatility positions through variance swaps. However, most dealers say it should be straightforward to manage the volatility risk on their books, either by repackaging the volatility into structured products aimed at retail investors or laying it off with hedge funds.

Risk repricing has also been evident in the dividend swaps market. Dividend swaps have a payoff that depends on the difference between future aggregate dividends of a stock index over a given year and an agreed dividend strike price. Growth rates implied by swaps maturing over the next 10 years have tumbled since early July. For instance, an S&P 500 2009/10 financial year dividend swap was pricing in an implied annual growth rate of 6% on July 10, according to Deutsche Bank. By August 23, the implied rate had plummeted to 2.9%.

Elsewhere in the equity derivatives market, there appears to have been a lot of de-leveraging activity in August. “We have seen various transactions in dispersion, for instance, that suggest liquidations have been happening,” says Valenzuela. Equity correlation traders and volatility arbitrageurs put on dispersion trades, seeking to profit from moves in index implied volatility versus single-stock implied volatility.

See also:Central banks act again as credit crisis continues
UK pensions still exposed to volatile equities
Subprime crisis forces carry trade unwinds

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