Low yields and record-high stock markets are prompting more and more investors to consider derivatives. Michael Marray explores why volatility trades are proving particularly popular, and how banks have responded to meet investor demand.

Marc Saffon

Over the past few years, many new investors have moved into derivatives strategies such as equities volatility and dispersion as an alternative asset class. They are now taking the firsts steps to add the same strategies in the credit space, such as playing the difference between credit default swap (CDS) index contracts and the constituent single names.

The main driver is low returns in fixed-income markets. Indeed, safe portfolio investments such as 10-year US Treasuries are yielding just over 2%, while 10-year bunds were yielding 0.294% in mid-June. At the same time, stock markets are at record levels, making pension funds and asset managers wary of adding to their holdings.

The result is a move towards derivatives strategies to generate additional yield, using structures that asset managers and pension funds have utilised for hedging purposes.

Trading volatility

However, the S&P 500-based Chicago Board Options Exchange Market Volatility Index (VIX) has been languishing at low levels, despite concerns about stock markets at record highs. In addition, volatility has generally been low on the VStoxx, the European volatility index based on the Euro Stoxx 50.

This has led to limited opportunities in simply trading the variance between implied and realised volatility, either via over-the-counter (OTC) swaps or exchange-traded instruments. It has pushed highly sophisticated investors into more complex trades.

The unexpected outcomes of the 2016 UK Brexit referendum and US presidential election have put the trading of volatility around elections firmly on the agenda, in addition to events such as central bank meetings to decide on interest rate rises, or the release of important economic statistics.

Traders put on big positions around the French presidential election, held over two rounds in late April and early May. Trading ahead of the June UK election was heavily concentrated in the foreign exchange (FX) markets, and there is now positioning on equity volatility ahead of the German election, and a possible Italian election. In addition to VStoxx variance, there is likely to be activity around the changing spread between the VStoxx and the VIX.

The US market is often described as being in a period of low volatility, based on the VIX index. However, Marc Saffon, global head of engineering at Société Générale Corporate & Investment Banking (SG CIB), notes that individual stocks and sectors within the index have experienced unusually large amplitudes in their performance, which is not consistent with their low implied volatility. "When president [Donald] Trump was elected there was a big rotation on which stocks were favoured and which were not, with, for example, infrastructure and energy stocks outperforming, and many value stocks and tech stocks underperforming poorly,” he says.

Dispersion strategies

Value strategies, which have outperformed for the past few years, took a big hit. But since February this year, the so-called 'Trump trade' has faded away somewhat, and sectors that benefited from the election have been struggling.

Against this background, dispersion trades are growing in popularity, with many funds adding a basket targeting dispersion. For example, in May the UK-based Invesco Perpetual Global Targeted Returns Fund (which has £9.7bn [$12.42bn] under management) added a volatility strategy. Its equity-dispersion idea involves a long-term trade that aims to take advantage of the continued low correlation between S&P 500 constituents and the index itself. The realised correlation of stocks within the S&P 500 has fallen. This reflects the less ‘macro’ nature of the equity market, relative to the past, and indicates that individual stock returns are starting to diverge.

But the biggest volumes have been based on capturing volatility changes around calendar events. “The French election was the biggest event during the first half of the year for hedge funds to position around, and we saw increased volumes on EuroStoxx 50 options to take directional bets, as well as some of the largest volume ever on V2X [VStoxx] futures and options to trade volatility,” says Walid Maaouni, head of equity derivatives sales to hedge funds at BNP Paribas.

The timing was particularly interesting for sophisticated hedge fund traders. The April contract (effectively a forward reading of the implied volatility of the EuroStoxx 50 Index for the next 30 calendar days between April 19 and the standard monthly SX5E option expiry on May 19) expired on April 19, a few days ahead of the first round of voting in France. But by the time the May VStoxx contract expired, both rounds of the election would be over, and the result known.

Mr Maaouni says a popular trading strategy was to sell puts on the V2X April contract to fund a long put position on the May V2X contract. “The theory was that the April V2X should have a fundamental floor, since the contract priced the uncertainty around the twofold event, and yet expired before the outcome of the first round," he adds.

Managing banks’ risks

For events in which the market has a binary view of which outcome it prefers, and which it believes is relatively certain, some investors with long equity portfolios add volatility trades to enhance their returns.

But for the big banks structuring derivatives deals for their clients, it is considered unwise to make any assumptions about likely outcomes, including of elections based on polls. For the major derivatives providers, the key is to offer their clients liquidity in good times and bad, which means a strong focus on managing the risk in their own book. Many are also offering more transparent options pricing methodology, so that clients following a particular strategy can model how it might look in a period of market volatility.    

“The banks are not here to take political risk, or to make money out of political events, and our focus is on continuing to provide liquidity to our clients, while hedging out as much of the risk on our book as possible. And where we aren’t hedged, make sure there is no huge concentration in one position”, says Mr Saffon. “For the French election the polls towards the end of the campaign were fairly clear, but for us it was important to put a stress test in place and look at the tail risk.”

In the equities options space, highly liquid underlying futures and options markets ease the way for banks to manage the risk on their own books. But offering exotic options in the credit space is more challenging, even though a growing number of investors are showing an interest in pay-offs such as credit volatility variance.    

A pick-up in credit trades

In the coming years Aritra Banerjee, credit derivatives research analyst at Citigroup, expects more institutional investors to add credit volatility to their portfolios to take exposure to volatility, to hedge, and even to generate yield – just as many already do in equities volatility via the VIX index. “Volumes we have seen in the CDS Index options market have been doubling pretty much every year,” he says. “It appears that investors have realised that it makes sense to use options as cheap hedges, instead of building a basket of credit default swaps.”

Like those in other asset classes, credit options give investors exposure to volatility and spreads. For highly sophisticated investors such as hedge funds, investing in the CDS option space can generate high returns because of structural aspects of the market.

As with other derivatives markets, at first the primary purpose is hedging, says Mr Banerjee. But whereas equity and FX markets are far advanced, credit remains a young market by comparison, so the main bias remains towards hedging, meaning there are more options buyers than sellers.

“The result is that systematically selling options in credit derivatives has been a profitable strategy, and one that we are seeing more and more of,” says Mr Banerjee. “As the market becomes more advanced, a growing number of investors are looking at more exotic products, such as variance swaps and digital options. Credit is at the beginning of that evolution.”

Citi has compiled a broad measure of credit market volatility, the Credit VIX, which several investors have been tracking. The methodology follows that of the VIX, though the Credit VIX is not currently a traded instrument. Given the market remains constrained by certain features, including a lack of exchange trading and difficulties in fixing, facilitating the trading of more exotic structures remains problematic.

OTC versus exchange listed

As equity volatility becomes a more popular trading strategy, both OTC and exchange-traded volumes are increasing. Mr Saffon sees this growth continuing in parallel. “OTC still provides investors with flexibility that listed futures and options do not, and even in listed markets liquidity can be an issue.”

He sees a trend of investors wanting more transparency, including on their OTC trades. “A lot of what we do for clients involves strategies where we provide an objective methodology towards designing the price of an option,” says Mr Saffon. “So, for example, investors can see how the option would price during a particular market spike.”

The implementation of rules on uncleared swaps (many standard swaps must now be cleared) seems to suggest that regulators are comfortable with large OTC volumes in parallel with listed markets, now that new margin requirements are being introduced to reduce counterparty and systemic market risk. Market players note that even if all OTC derivatives business in areas such as volatility were gradually pushed onto exchanges, it would not create any additional global liquidity, but simply transfer liquidity from one part of the market to another.  

Providers and users of OTC swaps are in the midst of establishing credit support annexes and other agreements covering requirements on initial and variation margin. The industry was not ready by the March 1, 2017 deadline, but both EU and US regulators have shown some flexibility by not taking action against firms still getting up to speed on full compliance. OTC derivatives houses in Europe are confident that all the necessary agreements will be in place by the August deadline.

Transatlantic influence

Meanwhile, with the VIX dominating the global market on listed volatility products, other exchanges are looking at launching new instruments, or making alterations to their existing product line up, to attract more investors. 

Eurex, part of the Deutsche Börse Group, is making changes to its volatility options, while traders also say Eurex Variance Futures (EVAR), launched in September 2014, has struggled to gain traction with the investor community, and could benefit from some adjustments.

Regarding its EuroStoxx 50 Volatility Index options, instead of options on the level of the VStoxx (OVS), Eurex is switching to options on VStoxx futures (OVS2). As of February, no new expiration months have been added to the OVS, which will be totally phased out after the September 2017 expiration.

This change has big implications for the US, which traditionally restricted the types of investors allowed to trade the OVS. By using options on futures, the OVS2 has obtained approval from the Commodity Futures Trading Commission to open it up to all market participants. 

Zubin Ramdarshan, head of product research and development equity and index at Eurex, expects the OVS2 to attract more US investors, and therefore increase global VStoxx options trading volume and interest. He highlights the importance of having exchange-traded notes (ETN) based on the VStoxx, such as the two new VelocityShares volatility-linked ETNs used by sophisticated investors in the US.

“The VIX benefits from very significant volumes associated with VIX ETNs, and VStoxx is moving towards the same kind of trading ecosystem,” says Mr Ramdarshan. “Some clients that a few years ago would have only used VStoxx as a hedge for their long equity portfolios have now added volatility as an asset class, and are trading on movements in the VStoxx, or putting on relative value trades such as VStoxx versus VIX.”

By its nature, the S&P 500 is a lower volatility index than the EuroStoxx 50. This, in comparison, is quite concentrated with 50 underlying stocks, and has a heavier weighting of financials.

“The spread between the VIX and VStoxx is itself quite volatile, which gives hedge funds and asset managers opportunities for relative value trading,” says Mr Ramdarshan. “For example, we saw a big movement in spreads during one particular phase of the Greek debt crisis in summer 2015, and also around the Brexit referendum in June 2016.”

Though hedge funds are still more likely to look for this type of pay-off, the number of asset managers that are adding volatility as an asset class is increasing, he adds. 


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