Vexed by variance

Variance swaps

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While many traders cheered the return of equity volatility in May and June, not all saw it as an opportunity for greater returns. For some investors, particularly those with short volatility positions through variance swaps and dispersion trades, the pick-up in volatility caused millions of dollars in mark-to-market losses. The losses haven't had a terminal effect on volatility trading - only one or two desks are thought to have retreated from the market, unlike last year, when losses in the convertible bond (CB) arbitrage market caused several banks and hedge funds to close their CB arb desks. But some argue that the losses have caused some firms to reassess their risk management processes.

Variance swaps, which have a payout equal to the difference between realised variance and a pre-agreed strike level, multiplied by the notional value, have been popular since 2004. With volatility falling dramatically in 2003 and 2004, investors used variance swaps to express views on the future direction of volatility (variance is the square of volatility). And with many expecting that equity markets would remain benign, they took short positions, either directly through variance swaps or through dispersion trades, which have a payout equal to the difference between the variance of an index and its component stocks.

The market for variance swaps has grown sharply over the past two years. Deutsche Bank estimates that volumes grew fivefold last year and are up 50% year-on-year for the first half of 2006. According to BNP Paribas estimates, daily trading volumes for variance swaps on indexes reached $4 million-5 million in vega in the first half of 2006. Vega measures the change in an option's price caused by changes in volatility. Credit Suisse, meanwhile, reckons daily trading volumes are around EUR2 million-3 million in vega, compared with EUR250,000-500,000 three years ago.

However, when volatility spiked in May and June - a result of a pick-up in inflation, anticipated interest rate hikes and a sell-off in emerging market assets - hedge funds and prop desks were caught off guard. 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, jumped from 13.35 points on May 16 to 18.26 points on May 23. On June 13, it closed at a year high of 23.81 points before falling to 13.03 points on June 29 (see figure 1). The result was hundreds of millions of dollars in losses for hedge funds, asset managers and some dealers.

London-based F&C Asset Management's Amethyst equity volatility fund, for example, took a hit on the back of variance swaps trades, says the fund's manager, Stephen Dolbear. "The majority of our drawdown after May 10 was due to variance swaps," he admits. The net asset value of the fund dropped by about 10% from EUR141 million on May 10 down to EUR123 million on June 1. At the start of July, the fund's size was around EUR130 million.

Amethyst was not alone. "Pretty much everybody lost a bit of money in the first part of the event, and then afterwards we certainly weren't prepared," says Maurizio Ferconi, a managing director in the financial engineering division at Putnam Investments, a Boston-based asset management firm. The company had put on several variance trades in the first quarter of this year and entered May short volatility. "But we don't have big positions in these instruments because there's all sorts of operational issues on scalability," says Ferconi, adding that the person who put on the trades left the firm in June.

Dealers, too, were left nursing losses. Societe Generale, for instance, had a short volatility position through dispersion trades ahead of the spike in volatility in May. "I was an advocate of the trade. It happened to be the wrong trade," says Thomas Droumenq, a managing director in hedge fund sales at Societe Generale in New York. "We didn't lose too much. We're having a very good year." Some investors, however, were not so lucky. "A lot of hedge funds lost 75-80% of their profit and loss in the year to date on these trades," adds Droumenq.

The most popular trades involved directional plays on volatility. For example, if an investor were to sell a variance swap on the Eurostoxx 50 index with a volatility strike of 12, and the realised volatility at expiry of the contract were 18, the investor would have to pay the square of realised volatility (18) minus the square of the volatility strike (12), times the vega notional.

Also popular were dispersion trades, which are based on the covariance of an index and its constituent stocks. Covariance measures the direction and magnitude of the moves between two groups. The investor is therefore taking a view on both variance and gamma, or the change in the option's delta with respect to the underlying stock price. For instance, an investor might put on a dispersion trade by buying variance swaps in single stocks and selling a Eurostoxx 50 variance swap, if he has a view that the volatility of individual stocks will be greater than that of the index as a whole.

While most participants were burned by taking the wrong view on the direction of the market, the spike in volatility was exacerbated by the unwinding of short variance swaps positions, combined with increased delta-hedging of open positions in the options market, say dealers. "Hedging variance swaps is more of an art and might have been mismanaged by certain banks, which probably contributed to the recent spike in volatility as well. Some dealers are not as prepared - especially in dispersion and the more sophisticated correlation strategies - as you would expect, but they're still trying to participate in the business," says Aaron Ford, a managing director and head of institutional sales at BNP Paribas in New York.

Variance swaps can be hedged with a delta-hedged static set of call and put options with a range of strikes. However, the models banks use to hedge their risk can differ. One divergence is the strike range of the option portfolio. A theoretically perfect hedge would require an infinite amount of strike prices. Clearly, this is not feasible, so banks tend to use different strike ranges, extrapolate prices out of the range and interpolate within that.

For instance, Todd Steinberg, head of equities and derivatives at BNP Paribas for the Americas in New York, says there are tail risks that the French bank doesn't hedge because it's inefficient. The bank uses its own proprietary optimisation model to determine which strikes to use. Chris Craig-Wood, a managing director and head of equity derivatives correlation trading at Deutsche Bank in London, agrees: "Effectively, you want to take every strike. But the very out-of-the-money strikes aren't liquid, so you can't really trade those anyhow. That's where the science of the model breaks down."

Market-makers should always have a fundamental view of where volatility is going, says Steinberg. "But the reality is that we need to be there for our customer regardless of our view, so, in that scenario, the analysis becomes: what is an efficient way to hedge out the risk that your customer is asking you to take."

The dealer's structure is just as important as its models, adds Steinberg. He argues that having both a flow business and a structured products business is key to effective risk management of volatility trades. As such, banks have a means to offset volatility exposures in different parts of the business.

Dealers say that although some investors have been scared off from volatility trading, they will return to the market. In fact, there were some fairly commonplace trades where investors profited. For example, a relative value trade between the Nikkei 225 and S&P 500 stock indexes would have profited handsomely, says BNP Paribas' Ford. What's more, investors wouldn't have faced the large margin requirements needed to conduct the same relative value trade through vanilla options. Ford claims the options strategy would require as much as 20 times more margin. "So you would only make a 40% return instead of an 800% return over two years or three years. A variance swap drastically reduces the cost of managing a volatility position, as well as increasing the return on capital," says Ford.

Despite the recent problems, new users continue to enter the market. Putnam Investments, for example, is relatively new to the field, and although its variance swap trades suffered losses recently, the firm will continue to trade the products as part of its portfolio, says Ferconi.

Some, though, remain unconvinced about the product, a feeling reinforced by the recent tumult. "I'm not a fan," says Bernard Kalson, senior hedge fund manager and head of the volatility arbitrage programme at Societe Generale Asset Management. "It's like all structured products. It's nice and very beautiful, but when problems arise it becomes very difficult to manage. So if you can take a view on volatility yourself with very simple options, it's always the best choice."

Isda initiatives

Dealers have been working towards creating standardised documents for variance products over the past six months under the auspices of the International Swaps and Derivatives Association. Joe Elmlinger, global head of equity derivatives at Citigroup in New York, says the impetus behind the effort is "to expedite the processing of variance swap trades, so that we don't find ourselves like some other emerging derivatives markets have in the past couple of years".

Dealers say standardisation of the documentation will have a beneficial effect on risk management. Variance swaps, are usually one-off deals between a client and a broker-dealer. Therefore, the very same market event could have a different result for different clients. So, for example, a company might pay a large one-time cash dividend, which could lead to sharp jumps in the share price - but the calculations of realised variance in some contracts may be adjusted for the jump in share price, while others might not.

It means a firm could think it has hedged a long variance swaps position by selling a variance swap on the same name with another dealer. "But then it finds out that it has a completely different treatment for the same corporate action or market disruption event. Well, guess what, you're not really hedged are you?" says Elmlinger.

Areas that still need to be hammered out include how to define a market disruption event, how to deal with corporate actions, and whether to have a single over-the-counter clearing company, such as the New York-based Depository Trust & Clearing Corporation or London-based dealer-owned SwapsWire. "We're not there today, but I'm confident we will get there in the next six to 12 months," says Elmlinger.

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