Seeking a wider audience for sophisticated products

It seems that as soon as the existing line-up of so-called standard derivative products becomes familiar, more new products emerge. The latest – if exchanges, index providers and their banking sponsors have their way – will be variance swaps and exchange-listed volatility products.

Investors have long followed moves in volatility indices to track potential market moves. Volatility indices can give stock owners a general idea of the relative cost of protection. For example, if a volatility index value is relatively high, index option premium prices would be at relatively high levels and the option buyer would be required to pay a relatively high price. The reverse also holds true.

Dharmendra Patel, equity derivatives strategist at Goldman Sachs, says that interest in equity volatility is not limited to equity investors. “All sorts of investors, regardless of whether they mainly invest in equities or in other asset classes, have shown growing interest in looking at equity volatility. They have a perception of risk that is not always priced into the market and they want to trade that in a very pure form.”

Other characteristics that make implied volatility attractive include its tendency to be mean-reverting (meaning, for example, that the value of an underperforming stock will eventually rebound) and the fact that it is often negatively correlated to stock prices. Axel Vischer, senior product manager at Eurex, says: “Volatility is particularly interesting because it is negatively correlated to the market – if the stock market goes down, volatility goes up and vice versa. This feature means that, by introducing some volatility into an equity portfolio, one can reduce its risk profile and improve the potential return.”

Interest grows

Volatility indices – and trades linked to them – have been around for more than a decade, but interest in the asset class has recently been increasing. Dixit Joshi, managing director in equity-linked products at Barclays Capital, says, for instance, that the most commonly traded volatility instruments, variance swaps, have gone from being specialist tools to becoming a commonly deployed method of gaining portfolio diversification. “They are very useful products for more active traders such as hedge funds because they allow them to quickly and cleanly trade volatility, with none of the friction and costs otherwise involved,” he says.

In a variance swap, two counterparties to the trade agree on a reference variance level or ‘strike’. At the trade’s maturity, the difference between the level of realised variance over the life of the swap and the pre-determined strike, multiplied by the notional amount of the trade, is then paid to the buyer of the variance swap, if positive, or to the seller if negative. According to Mr Joshi, one of the great advantages of variance swaps over some of the other ways in which volatility can be traded is that they are easy to replicate and risk manage. He says that the market in variance swaps is already well established and liquid, with tight bid-offer spreads. Barclays Capital recently went a step further, adding the products to its electronic BARX platform in a move that he hopes will further enhance the market’s transparency and the tradability of the products.

According to estimates from Bank of America analysts, Glen Taksler and Jeffrey Rosenberg, about 60% of variance swap market participants are hedge funds and proprietary trading groups, one-quarter of participants are dealers, and the remaining 15% are largely pension funds and insurers. Mr Patel more or less concurs with these estimates but notes that retail and private clients have also expressed strong interest in the product. Hitherto, however, they have only been able to access volatility through sporadic structured product vehicles, which he says have been operationally challenging for investment banks to put together.

Mr Patel believes that recent moves, such as the Chicago Board Options Exchange (CBOE) and Eurex’s recent introduction of volatility futures, should help to remove these barriers.

Indices redesign

The most widely followed volatility indices in Europe and the US were recently redesigned closely following the measures used to trade over-the-counter (OTC) variance swaps. This was done specifically to ensure ease of trading and to facilitate the subsequent launch of related futures and options contracts. First off the ground with an index redesign and contract launch was the CBOE with its so-called Volatility Index Future (VIX) future, which listed in March 2004. The VIX is based on the CBOE Volatility Index (now known as the New VIX), which in turn is derived from S&P 500 Index option prices. The VIX futures are listed on the Chicago Futures Exchange, an all-electronic arm of the CBOE.

More recently, the Swiss/German exchange, Eurex, debuted a European family of volatility futures based on the VSTOXX indices for volatility in the euro area, the VSMI index for volatility in the Swiss equity market, and the VDAX-NEW index for volatility in the German equity market. Earlier in the year, Deutsche Börse and Goldman Sachs had jointly redesigned the VSTOXX, VDAX-New and VSMI indices using the updated methodology.

Despite high-profile debuts, sentiment about the usefulness of the new contracts is mixed. When the New VIX index was launched in 2003, Goldman Sachs’ analysts Altaf Kassam and Tarun Sharma said that the amended features would mean that investors could use contracts linked to it to speculate on the future level of implied volatility in a pure manner, “uncontaminated” by the directional movements of the underlying stocks. They said investors could also use the futures to diversify against long-equity positions and to hedge against any structural exposure to future implied volatility.

Mr Patel says Eurex’s new contracts should open up volatility trading to investors that have been restricted from OTC trading or find it operationally demanding, as well as facilitating the launch of retail structured products.

Mr Vischer says that Eurex specifically set out to create what he calls “a more simple product”, suggesting that some traditional buyside clients have found the variance swaps too complex to use or manage.

Simple trading

Mr Joshi believes that there are no such barriers to variance swap trading. “The mathematics behind variance swaps is complex, yes, but the same could be said for many derivatives or structures that have seen widespread adoption. What is key is that trading a variance swap position is relatively simple. Investors wanting to go long volatility at 17% will lift an offer at 17, and own it at 17; if the realised volatility is higher they will earn money, if it is lower they will pay money. It is a clean and simple way to execute what was once a complex trading strategy involving multiple options trades, gamma hedging and ongoing rebalances,” he says.

Despite the possibilities outlined earlier, traction in the VIX futures has been lacklustre. In early January, open interest in the VIX contract totalled just 8764 contracts. Similarly, Eurex’s volatility futures have failed to garner any significant momentum since their launch last September. Mr Patel admits that volume in the new Eurex contracts has disappointed him but adds: “My expectation is that volumes in the listed contracts will pick up at some point. Investors will see they have become more liquid and they will gradually become widely accepted.”

Mr Vischer says that Eurex initially expected volumes to be significantly higher than they have been. However, he maintains that there has at least been a lot of interest in the product. “This is a new market and it is a sophisticated product, so it is not surprising that volumes have not immediately soared. Lots of education still needs to be completed before a wide range of investors will be comfortable using the contracts,” he says. For the time being, Eurex is running roadshows all around Europe to promulgate the product to different investor segments.

Product clarity

Mr Vischer believes that the fast-changing regulatory environment appears to have left some fund managers unclear about what products they are allowed to invest in, including volatility futures. He expects that once such confusion is resolved, investors will have a greater level of comfort with the contracts. In the near term, Mr Vischer expects the main users will be fund managers, particularly small and medium-sized institutions, and that at a later date retail investors will use the contracts as they gain familiarity with them and liquidity improves.

With its similarity to the CBOE’s VIX future, he also hopes that Eurex’s contracts will present arbitrage opportunities to those seeking to trade between the two markets – an element that may also encourage further hedge fund participation.

Once they are more liquid, the futures should facilitate OTC hedging in volatility-related and variance-related products by structurers and traders at investment banks. This should help investment banks to put together structured products for an apparently eager retail market, as well as enable them to offset other trades on regulated futures markets.

Fixed-income investors, who look at the relationship between volatility and credit spreads, might also use them for hedging purposes, when the volatility appears cheaper than buying credit protection on a portfolio.