Prepackaged Volatility Plays
Two new products hope to make volatility trading a no-brainer.
All derivatives traders know that option prices really boil down to the market's expectation of the future volatility of the underlying instrument, because all the other determinants of an option's price—the underlying price, time to maturity, interest rate and strike price—are objective. Volatility is the X factor, and only rarely does an option's actual, realized volatility replicate the implied volatility reflected in its valuation.
Traders typically hedge implied volatility by constructing elaborate—and often highly expensive—series of short and long straddles based on differing strike prices, styles and expirations. Although over-the-counter volatility structures have been offered for years, they have been highly illiquid and do not offer price transparency—characteristics sure to scare off traders.
Now volatility traders will have a much easier time of it, thanks to two new products released in January: volatility futures from the Deutsche Terminborse and volatility swaps from Salomon Smith Barney.
The DTB became the first exchange in the world to list volatility futures based on an underlying index of implied volatility when it launched the VOLAX future on January 19. The VOLAX is based on the implied volatility of its DAX index options, which is represented by the VDAX, a set of eight volatility indices introduced by the DTB last summer.
VOLAX futures allow traders of DAX options the ability to manage their volatility risk in a single instrument. "There are certain traders in the market who play with volatilities to trade volatility strategies,” says Elmar Werner, product developer at the DTB. "It is much easier for them to use the VOLAX instead of a combination of DAX options. It's cheaper in terms of the exchange fees, and you don't have to look for the combinations. It's a single product that's more efficient and easier to use.”
VOLAX futures have a number of other uses as well, including hedging warrant issues; eliminating the vega component (the change in an option's price caused by changes in volatility) upon the creation of delta (the degree of change in an option's premium, based on changes in the underlying) or gamma (the rate of change of delta) positions; and facilitating the buying or selling of options upon extremely high or low volatilities for DAX option market makers who are obliged to make binding quotes. The instruments can also be used to speculate on rising or falling volatilities, to exploit mispricings across the DAX option volatility curve, to arbitrage against DAX options, and to serve as the underlying for warrants. (See box.)
But what about traders who aren't exposed to the DAX but want to hedge their volatility risk? Salomon Smith Barney thinks it has the answer for them. In January the firm began promoting volatility swaps, a product meant to appeal to traders who want to hedge their volatility exposures without constructing elaborate and unwieldy positions—and who thus want to escape bid-offer spreads, commissions, clearing costs and the various trade-support costs that the listed markets reap.
Volatility swaps are traded as follows: Salomon Smith Barney enters into an OTC agreement with a counterparty. At maturity, the value of the swap depends only on the realized volatility of the asset, and not the volatility path the asset has taken during the life of the trade, which can sometimes make for higher costs in traditional listed volatility structures. The investor merely contracts with Salomon Smith Barney, which either buys or sells an option portfolio, delta hedges the portfolio and pays the customers the positive return or collects the negative return. Salomon takes care of all the operational costs, including risk management, systems, traders, back office and clearing.
Volatility swaps have several applications. Customers can sell swaps on the one-year volatility of the Standard & Poor's 500, an attractive proposition for those who don't expect the market to crash in the next 12 months. The S&P one-year volatility is currently trading around 25 percent, even though realized one-year volatility has rarely exceeded 18 percent, largely as a result of investor nervousness. Corporates can short individual stock volatility to hedge their volatility exposures when planning to issue convertible bonds. According to Salomon, "if volatility were to decline, the higher coupon the company would have to pay would be offset by the positive value of the swap at maturity…[while] if the volatility were to increase, the convertible to be issued would be more valuable…[so] the company could pay a lower coupon.”
Many funds have positions in Japanese converts and warrants, leaving them long volatility of individual stocks. Since there are no listed option markets in Japan for equities, shorting some stocks can be difficult. Salomon's new swap products allow investors to hedge their long volatility positions in Japanese equities by selling one-year or even two-year Nikkei volatility to Salomon. In addition, index funds can use Salomon volatility swaps to reduce the amount of tracking error that could attend massive increases in market volatility.
Some have predicted that volatility will become the next big asset class. Salomon and DTB certainly hope that's the case more rather than less, sooner rather than later.
|Arbing the VOLAX
The VOLAX could present tremendous arbitrage profit possibilities if it is mis-priced early on. According to the DTB, by constructing a "replication portfolio” of the VOLAX, traders can arbitrage overvalued VOLAX futures relatively easily. For example, say the fair price of the VOLAX is DM 1,575, but the VOLAX is traded at DM 1,600—an arbitrage window of DM 25. To arbitrage 100 VOLAX futures, a replication portfolio consisting of 102 long straddles expiring at Tl and 80 short straddles expiring at Ts is constructed, paid for by borrowing from the money market. The delta of the replication portfolio is 19.72, far below that of a DAX future. At Tl, the VOLAX is no longer mispriced, so the arbitrage window closes. The forward volatility at Tl has risen to 16.25 percent, and the DAX has fallen by 50 points, so the VOLAX is now traded at DM 1625. Buying back 100 VOLAX futures therefore results in a loss of DM 2,500, but this is divided into the loss resulting from the change in fair futures price, which is DM 5,000. The result: a profit of DM 2,500.
—Source: Deutsche Terminborse
The Post Bashes Morgan
The New York Post is not normally the first place you'd turn for articles about RiskMetrics. On March 8, however, columnist John Dizard mocked Morgan's risk management systems for failing to predict the $587 million fourth quarter earnings loss the bank holding company designated as "nonperforming assets, primarily swaps.”
The problem, claims Dizard, goes to the heart of the bank's ability to control risk. Instead of chasing the retail credit card businesses like other banks, he explains, Morgan decided to take the less traveled road and become a global derivatives player. "There was, however, a reason that this road was less traveled by—it was studded with land mines.”
RiskMetrics, he says "uses the same probability theory analysis that a serious gambler would employ in estimating his risk/reward ratio—Morgan may have ordered RiskMetrics from the same Acme Co. that used to supply Wile E. Coyote with those rocket-powered roller skates.”
He goes on to quote an unnamed source on the merger rumors swirling around the bank. "I think of them as pink, trembling aristocrats worrying about how their cruel new barbarian masters will use them,” says the source. "They want to be rescued by someone like Deutsche Bank, but Deutsche doesn't need the name. Someone with a lot of money and not so much class will move in.” By now everyone has heard that 1997 was a record year for most major options exchanges. But many would be surprised to learn that much of that growth was fueled by individual stock options, as opposed to index options, despite the success of new listed index products such as the Chicago Board Options Exchange's options on the Dow Jones Industrial Average.
How to explain the relative success of equity options? Let Goldman Sachs count the ways. In two recent research reports, "U.S. Stock Options Move to Center Stage: A Look Behind the Scenes,” and "Relative Value in U.S. Stock vs. Index Options: Is Dispersion Cheap?” Goldman researchers explain why equity options have soared, and what investors should do about it.
In the past three years, stock option activity has increased at an annual rate of more than 20 percent. A number of developments point to continued success of equity options. The growth of hedge funds with a stock focus, in which managers use stock options to leverage equity views and to implement bearish views with more precision than index options, has had a profound effect. In addition, a more subdued equity market, which Goldman believes is in the offing, should place additional emphasis on stock selection more than overall market performance. There has also been an increased desire on the part of wealthy investors to hedge the capital gains they have realized in concentrated stock funds, and an increasing prevalence of stock options in employee compensation structures, which increases general familiarity of equity option products. The bustling long-term equity anticipation securities (LEAPS) market has contributed as well, allowing investors to take longer views on particular equities.
The report also points to an increasingly beneficial regulatory environment, including wider position limits for those using the equity hedge exemption, the removal of position limits on equity FLEX options and the Securities and Exchange Commission's move to model-based capital requirements for listed broker-dealers.
In addition, changes to the tax law, such as the elimination of the short-short rule, have made options more tax-advantageous to investors. Goldman also argues that there has been an increasing acceptance of derivatives in the financial world, and that an increase in corporate restructurings has enticed many investors to use options to speculate on potential merger and acquisition activity.
As if that weren't enough, Goldman asserts that the volume of calls as a percentage of total volume has hovered around 70 percent for equity options, whereas it has struggled to reach 50 percent for index options. This indicates that while investors use equity options for leveraged investments, they use index options primarily to hedge their broad-based exposures. "In light of the strong U.S. equity market returns in the last few years,” says Goldman, "such index option strategies may have fallen in the shadows…As growth of the U.S. market slows to a more ‘normal' pace [this year], stock selection and sector rotation are likely to become of increased importance.”
But how can investors capitalize on this trend? Goldman notes that "the spread of stock option to index option volatility was in a general trend of widening during the early 1990s as implied index volatility fell sharply and stock option volatility was stable. Since mid-1994, however, the spread has narrowed and may now be poised to begin another multiple-year rising trend as bottom-up forces that emphasize stock selection gain in relative importance.” Further, correlation is poised to decrease, says Goldman, so stock option strategies are preferable to index option strategies "to capture any increase in the dispersion across stock returns.” With this in mind, Goldman offers three possible strategies for investors:
- Favor option positions that are long volatility on extremely attractive or unattractive stocks. Replace or augment stock positions with call options or call spreads (long at-the-money call/short out-of-the-money call) as a way of capturing the upside of value-added stock selection while limiting downside exposure.
- In buying stock options vs. sector options, be sensitive to sectors where innovation or market developments shift the returns across participants dramatically, as in technology and consumer nondurables, where competition is intense.
- Favor short or neutral volatility positions in index options for risk management by selling out-of-the-money call options at target index levels or using long put/short call strategies for downside hedging.
For a copy of the reports, contact Joanne Hill at 212-902-2908.
Rogue Trading Insurance
The Titanic, Bruce Springsteen's voice, NASA satellites and countless other odd and famous objects have been insured by Lloyds of London contracts over the years. Now, in an effort to protect customers from the Nick Leesons of the world, the venerable institution has begun offering insurance against rogue traders.
While other insurers offer policies to cover trading, they define fraudulent trading as breaking rules either to cause losses or for personal financial gain—in other words, stealing. In Leeson's case, however, Barings was not protected by its fidelity trading insurance because Leeson exceeded position limits not to bolster his commissions but to cover his earlier losses. The new Lloyds policies also cover unauthorized trading undertaken merely to get out of trading holes.
The policies, written by SVB Syndicates, a Lloyds subsidiary dedicated to specialty coverage of financial institutions, provide up to $300 million to cover direct financial loss caused by unauthorized, concealed or falsely recorded trading by any person trading for the insured institution.
"What we found when we looked at the losses in unauthorized trading was that quite typically they did not include dishonesty,” says Steven Burnhope, director of SVB. "It was often an action taken [simply] to make a profit. Our customers said to us that, with the emergence of trading as a major component of their earnings these days, the traditional products didn't address the risks that were emerging in those areas.”
While SVB's new policies cover only proprietary trading activities, another Lloyds subsidiary, Stone Financial Risks, is now offering policies geared toward securities brokers as well, offering protection for losses caused by dealers' clients.
The annual premiums for the rogue trading policies will range between $2 million and $10 million, with annual deductibles of between $10 million and $25 million, to be determined on a case-by-case basis. SBC and Stone will examine each firm's internal risk management framework, making sure that solid trading controls are in place. Neither plans to issue policies to firms that fail to meet the basic requirements. In January, Chase purchased the first policy, and some 40 other financial institutions have asked for quotations thus far. Since Lloyds represents 60 of the world's 100 largest banks, it hopes that the policies will take off.
"We didn't know at the beginning if we would be able to provide cover in this area,” says Burnhope, "because it is one that insurers have found quite difficult to assimilate.” It is clear now, however, that with these policies another level of risk management tool has emerged. Is reinsurance of rogue trading policies far off?
Free Data from Dr. Ed!
In 50 years, derivatives traders around the world will lionize Dr. Ed Yardeni, chief economist and managing director at Deutsche Morgan Grenfell, as a true pioneer in the history of data vending. Not only does his ground-breaking financial web site, www.yardeni.com, provide boatloads of historical data useful to traders everywhere—it does so for free. Dr. Ed is in it for the love, not the money. Are you listening, Michael Bloomberg?
"I hope my site will be your number one source for economic and financial information,” he writes near the top of his main page, and he follows this bold statement of purpose with a barrage of economic information that is certainly up to the task.
Most useful to derivatives players are the site's "chart rooms,” which offer general statistics on U.S. markets (stocks, interest rates, foreign exchange rates, financial futures and commodities); emerging markets (Asia, China, Latin America, India and Mexico); U.S. trade (business, consumers, trade, flow of funds, inflation, industry and history); industrial regions (G-7, Australia, Canada, France, Germany, Italy, Japan and the United Kingdom); and daily and weekly charts on just about every important financial subject, from commodity and financial futures in the United States and European and Asian stock prices to interest rates, yield curves and inflation numbers.
As if all of that weren't enough, Dr. Ed offers web surfers his own published material, including Weekly Economic Analysis, Weekly Economic Briefing and the Y2K Reporter; articles on "cybereconomics”; a slew of monetary and fiscal policy statistics; articles on economic history, demography and marketing; instant fax-on-demand services; a downloadable market ticker; and a copious list of links to every imaginable related site. For spendthrift surfers, he offers additional fee-for-service material.
The site has received lavish praise in the financial community and has won numerous awards, including a number 11 ranking on Future.net's list of top web sites for futures traders.
With all of this stuff to mull over, will any of us have time to work?
CMRA Surveys Market Risk Reporting Techniques
Last year, the Securities and Exchange Commission announced it would allow companies to choose between three different methods to fulfill market risk disclosure requirements. Derivatives users could choose between tables of individual risk factor data, sensitivity analyses or value-at-risk-type information.
Which method will companies be using to fulfill these requirements? According to a January 1998 survey of some 30 financial firms and corporations by Capital Market Risk Advisors, 80 percent of the respondents indicated their disclosure methods would involve techniques similar to those they already use for internal risk measurement and reporting.
Most banks and broker-dealers already use value-at-risk internally to measure the risk of their trading activities, and most of these plan to use VAR to disclose the market risk of trading activities to the SEC, though they may not use VAR in disclosing nontrading activities.
The majority of insurance companies surveyed, meanwhile, use sensitivity analysis to meet regulatory reporting requirements, and most of these plan to use the technique to meet SEC requirements.
By contrast, most of the smaller firms that do not currently use VAR plan to use tables of individual risk factor data to comply with the SEC requirements.
The survey discovered a number of interesting VAR-related factoids:
- The length of the observation period used in the calculations will range from less than one year to more than three years.
- The amount of VAR generally represented less than 1 percent of the respondents' book values among broker-dealers and banks that offered their 1997 statistics.
- More than 90 percent of these plan to use VAR calculations for pricing models rather than for concrete changes in earnings, values or cash flows.
- The most common model is the analytic variance-covariance VAR, with aproximately 50 percent selecting this method by itself. Most cited the less computationally intensive nature of this calculation relative to historical VAR (20 percent of respondents), Monte Carlo-based VAR (25 percent) or other stimulation methods (5 percent).
- Twenty percent of the VAR-using firms ignore nonlinearity positions altogether, while 25 percent of the respondents made adjustments for option holdings by measuring the delta of their positions. Another 30 percent made adjustments using both delta and gamma.
- In general, those firms using VAR take into account the correlation effects across risk exposures both within and across instrument types. For about 90 percent of the respondents, use of empirical correlations is the preferred methodology.
- All of the bank and broker-dealer respondents plan to use a one-day holding period, while insurance companies and corporates plan to use periods of two weeks to one year.
- Of the firms that plan to use sensitivity analysis, all plan to use actual, observed fair values rather than pricing model computations. Unlike the VAR-using firms that account for volatility and correlation, sensitivity analysis-using firms plan to show the sensitivity only to price changes and market factors such as currency rate or interest rate changes.
For more information on the survey results or to complete the survey, write or send a fax to:
Capital Market Risk Advisors
565 Fifth Avenue
New York, NY 10017