The strategy takes advantage of a steady imbalance between the implied volatility derived from the price of options on the Standard & Poor's (S&P) 500 equity index and the actual volatility later displayed by the market over the option's lifespan. In general, Merrill Lynch says, implied volatility is 4.7 points higher than realised volatility, providing an arbitrage opportunity.
To exploit the arbitrage, which most likely is due to the fact that investor demand for index volatility tends to oustrip supply from dealers, the new index uses a three-month variance swap together with a cash investment.
The mechanics of the index work as follows: the variance swap is sold short at the close of each third Friday of specified months: March, June, September, and December. At each expiration the variance exposure is set such that the index level would fall to zero if three-month S&P 500 realised volatility were to exceed 80%, on an annualised basis.
The index would have outperformed most hedge fund benchmarks over the last 18 years, the bank says.
Later this year Merrill Lynch will launch more indexes which seek to emulate other common cross-asset-class hedge fund strategies.