VOLATILITY AS AN ASSET CLASS - FT Business

JUNE 2012
VOLATILITY AS AN ASSET CLASS
Societe Generale Corporate & Investment Banking
Global Markets Division | CROSS-ASSET SOLUTIONS GROUP
Julien Lascar – Cross Asset Solutions

CONTENTS
VOLATILITY:
● WHAT IS IT?
● WHICH VOLATILITY?
● WHAT TO DO WITH IT?
TAIL HEDGING
● HOW TO TRADE VOLATILITY
● VIX IS THE BEST EQUITY VOLATILITY INDEX
● ACCESS TO VIX
● CASE STUDY
ALTERNATIVE INVESTMENT
● VOLATILITY PREMIUM
● ACCESS TO VOLATILITY PREMIUM
● CASE STUDY
2

VOLATILITY
WHAT IS IT?
WHICH ONE?
WHAT TO DO WITH IT?
3

VOLATILITY
WHAT IS IT?
● A MEASURE OF RISK
● Volatility most frequently refers to the standard
deviation of the continuously compounded returns of
a financial instrument with a specific time horizon. It
is often used to quantify the risk of the instrument
over the time period.
WHICH VOLATILITY?
● IMPLIED vs. REALIZED
● VOLATILITY IMPACTED BY TIME PERSPECTIVES
(MATURITY), LEVEL OF RISK (STRIKE/SMILE)
● EACH UNDERLYING HAS ITS OWN VOLATILITY
● MODELISED DIFFERENTLY
Bp/day for HJM model (Interest rate)
%/year for Black model (FX, Equity, Commo…)
WHAT TO DO WITH IT?
● CAPTURE OPPORTUNITIES
4

VOLATILITY
WHAT TO DO WITH IT?
HEDGING: OPPORTUNITIES
INVESTMENT: OPPORTUNITIES
TAIL HEDGING ALTERNATIVE INVESTMENT
5

TAIL HEDGING
HOW TO TRADE VOLATILITY?
VIX IS THE BEST EQUITY VOLATILITY INDEX
ACCESS TO VIX
CASE STUDY
6

TAIL HEDGING
HOW TO TRADE VOLATILITY?
LISTED/OTC OPTIONS ON AN EQUITY INDEX
VARIANCE/VOLATILITY SWAPS
● Exchange of realized volatility at maturity with
a pre-determined fixed amount, The “Variance
Strike”.
● Spot Start, Forward Start.
VIX FUTURES
● The benchmark for stock market volatility,
measuring implied short-term volatility of S&P
500 Index options.
ETNs & ETFs
SYSTEMATIC FUNDS
Liquidity
Bid-Offer Spd
Cost of Carry
Roll Mgt
Flexibility
Transparency
7

TAIL HEDGING
VIX IS THE BEST PROXY
WHAT IS VIX ?
● The benchmark for stock market volatility,
measuring implied short-term volatility of S&P
500 Index options.
● Highly Transparent & Liquid – VIX futures
are exchanged traded on the CBOE.
● Tight Bid/Offer Spread – especially in
comparison to Vol and Variance swaps.
WHY VIX ?
● Negative Correlation with Equity Market
● When equity market are dropping, they all
move down
200%
180%
160%
140%
120%
100%
80%
60%
40%
20%
0%
SPX Index HSI Index VIX Index
8
350%
300%
250%
200%
150%
100%
50%
0%

TAIL HEDGING
ACCESS TO VIX – BASIC WAY
ROLL VIX FUTURE CONTRACTS
● But, the market is in contango most of the time
Future
Price
Time
COST
! OF
CARRY
9

TAIL HEDGING
ACCESS TO VIX – SMART WAY
SGI VI BETA INDEX – Calculated by S&P
The SGI VI Beta Index provides long implied volatility exposure through VIX futures.
The Index invests in the VIX futures contracts through a utility function, which aims to provide the best roll in
order to benefit from:
● The smallest carry cost 1 of the contango term structure (low volatility regime).
● The highest positive carry earning of the backwardation term structure (high volatile regime).
Positive carry in
backwardation
markets
The Index contains a dynamic exposure that leverages expo to VIX Futures when VIX is going in backwardation
The higher the volatility, the higher the exposure to the short-term futures contract.
High Transparency & Liquidity
1 Primarily invests from 1 st to 6 th contract
1/5 th of positions are daily rolled.
Negative carry in
contango
markets
10

TAIL HEDGING
CASE STUDY 1 - DIVERSIFIED PORTFOLIO (KOREA)
The increased allocation of the SGI VI Beta Index to the diversified portfolio shows enhanced
performance.
180
170
160
150
140
130
120
110
100
90
0
Jun-2007 Jun-2008 Jun-2009 Jun-2010 Jun-2011 Jun-2012
Diversified Portfolio
KIS Govt Bonds 5Y+ (KISKGV5Y Index): 75%
Korean Equities (KOSPI2 Index): 20%
Commodities (DJUBS Index): 5%
Diversified Portfolio
95% x Diversified Portfolio
+ 5% SGI VI Beta
90% x Diversified Portfolio
+ 10% SGI VI Beta
Since 18 Jun 2007 (5 Year) 6.90% 8.80% 10.68%
Since 1 Sep 2008 (Financial Crisis) 9.23% 11.49% 13.72%
Since 14 Mar 2011 (Launch Date) 5.54% 7.39% 9.22%
Source: Bloomberg as of June 18 th 2012
Diversified Portfolio
90% Diversified Portfolio + 10% SGI VI Beta Index
95% Diversified Portfolio + 5% SGI VI Beta Index
SGI VI Beta Index
700
600
500
400
300
200
100
Annualised Return Comparison
THE FIGURES RELATING TO PAST PERFORMANCES AND SIMULATED PERFORMANCES REFER TO PAST
PERIODS AND ARE NOT A RELIABLE INDICATOR OF FUTURE RESULTS. THIS ALSO APPLIES TO
HISTORICAL MARKET DATA
11

TAIL HEDGING
CASE STUDY 1 - DIVERSIFIED PORTFOLIO (HONG KONG)
The increased allocation of the SGI VI Beta Index to the diversified portfolio shows enhanced
performance.
160
150
140
130
120
110
100
90
0
Jun-2007 Jun-2008 Jun-2009 Jun-2010 Jun-2011 Jun-2012
Diversified Portfolio
iBoxx ABF Hong Kong TR Index (ABTRHK Index): 75%
Hong Kong Equities (HSI Index): 20%
Commodities (DJUBS Index): 5%
Diversified Portfolio
95% x Diversified Portfolio
+ 5% SGI VI Beta
90% x Diversified Portfolio
+ 10% SGI VI Beta
Since 18 Jun 2007 (5 Year) 4.18% 6.18% 8.16%
Since 1 Sep 2008 (Financial Crisis) 2.98% 5.42% 7.85%
Since 14 Mar 2011 (Launch Date) 0.53% 4.53% 2.53%
Source: Bloomberg as of June 18 th 2012
Diversified Portfolio
90% Diversified Portfolio + 10% SGI VI Beta Index
95% Diversified Portfolio + 5% SGI VI Beta Index
SGI VI Beta Index
700
600
500
400
300
200
100
Annualised Return Comparison
THE FIGURES RELATING TO PAST PERFORMANCES AND SIMULATED PERFORMANCES REFER TO PAST
PERIODS AND ARE NOT A RELIABLE INDICATOR OF FUTURE RESULTS. THIS ALSO APPLIES TO
HISTORICAL MARKET DATA
12

ALTERNATIVE INVESTMENT
VOLATILITY PREMIUM
ACCESS TO VOLATILITY PREMIUM
CASE STUDY
13

ALTERNATIVE INVESTMENT
VOLATILITY PREMIUM: IMPLIED VS. REALIZED
The observed difference between implied and realized volatility is called the volatility risk
premium
● In option markets, price inefficiencies exist due to a structural imbalance between volatility buyers and sellers.
● Market participants - generally large institutions – are mainly hedgers and have to buy at a premium to attract
capital into the derivative market.
Average
4.8% / y
40%
30%
20%
10%
0%
-10%
-20%
-30%
-40%
Average 1-month historical daily
volatility risk premium between VIX
and S&P 500
-50%
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
Source: Bloomberg, from 02/01/1990 to 15/03/2010
THE FIGURES RELATING TO PAST PERFORMANCES AND SIMULATED PERFORMANCES REFER TO PAST
PERIODS AND ARE NOT A RELIABLE INDICATOR OF FUTURE RESULTS.
14

ALTERNATIVE INVESTMENT
CAPTURE THE VOLATILITY PREMIUM – BASIC WAY
BASIC WAY: SHORT VARIANCE SWAP
● VARIANCE SWAPS ARE FORWARD CONTRACTS ON THE REALIZED SAMPLE VARIANCE OF RETURNS
OF AN UNDERLYING ASSET.
● THEY PROVIDE A LINEAR PAYOFF THAT IS A FUNCTION OF THE SAMPLE VARIANCE OVER THE
CONTRACT LIFE.
Advantages
Can be easily customised
LONG LEG:
IMPLIED VOLATILITY
SHORT LEG:
REALIZED VOLATILITY
Higher bid-offers
Less liquid, as OTC
Disadvantages
15

ALTERNATIVE INVESTMENT
CAPTURE THE VOLATILITY PREMIUM – SMART WAY (1)
SGI VOL PREMIUM DYNAMIC 2 INDEX
1. Trend Indicator
● “Trend indicator” to determine the position on the variance
swaps Long or Short?
● The Trend Indicator is a dynamic mechanism that looks at
different market parameters
short term realized volatility of S&P 500 Index
change in VIX
the observed volatility premium
2. Taking a Long/Short Position
● Positions taken each day in 1-month variance swaps, on a
fraction of the index value.
● The index is computed on a daily basis using mark-to-market
levels of the variance swaps.
Trend
Indicator
If positive
If negative
Trend Indicator
Short
The figures used in this example are given for purely indicative purposes, the objective is to describe the
mechanism of the product. It allows an understanding of how the product would have performed at different
market stages over previous years, but is no guarantee as to future returns and has no contractual value
Long
Short position in 1M
Variance Swaps
(40% leverage)
Long position in
1M Variance Swaps
(10% leverage)
Short position allows to capture the spread
between implied and realized volatility on the
S&P 500 Index.
Long position enables to quickly offset the
risk of a short realized volatility exposure in
volatile markets.
Seller of
variance swap
Buyer pays the swap strike
Buyer of
variance swap
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ALTERNATIVE INVESTMENT
CAPTURE THE VOLATILITY PREMIUM – SMART WAY (2)
3. Dynamic Exposure
● The dynamic exposure mechanism makes it possible to deleverage more quickly in case of a sudden rise of volatility
(40% leverage for a short position and 10% leverage for a long position).
● The Index tracks the performance of a variance swap’ portfolio¹.
1 The portfolio is usually made up of around 21 short or long positions, corresponding to the number of business days during the month.
2 Computed one day before
3 Number of business days corresponding to 30 calendar days since the launch of the previous variance swap (Trend Indicator is the
one observed for the week, not necessarily on that day)
The figures used in this example are given for purely indicative purposes, the objective is to describe the mechanism
of the product. It allows an understanding of how the product would have performed at different market stages over
previous years, but is no guarantee as to future returns and has no contractual value
17

SGI VOL PREMIUM DYNAMIC 2 INDEX
350
300
250
200
150
100
SGI Vol Premium Dynamic 2 Index S&P500 Index
1Y
SGI Vol Premium Dynamic 2
0.04%
5Y 7.48%
Since Launch
(14 Mar, 2011)
4.02%
Volatility (5Y) 9.74%
Sharpe 0.77
Source: Bloomberg as of June 18 th 2012
50
Jan-1999 Jan-2003 Jan-2007 Jan-2011
Source: Bloomberg as of June 18 th 2012
THE FIGURES RELATING TO PAST PERFORMANCES AND SIMULATED PERFORMANCES REFER TO PAST PERIODS
AND ARE NOT A RELIABLE INDICATOR OF FUTURE RESULTS. THIS ALSO APPLIES TO HISTORICAL MARKET DATA
18

IMPORTANT INFORMATION
The SGI VI Beta Index (The “Index”) is the sole and exclusive property of Société Générale (“SG”). SG has contracted with Standard & Poor’s (“S&P”) to maintain and
calculate the Index. S&P shall have no liability for errors or omissions in calculating the Index. The VIX® is the property of the Chicago Board Options Exchange,
Incorporated. The VIX ® Index has been licensed for use by SG in connection with the Index.
The SGI Vol Premium Dynamic 2 (The “Index”) is the sole and exclusive property of Société Générale (“SG”). SG has contracted with Standard & Poor’s (“S&P”) to
maintain and calculate the Index. The S&P 500® Total Return index is the exclusive property of S&P and the CBOE Volatility Index® (the VIX®) is the property of the
Chicago Board Options Exchange, Incorporated. The S&P 500® Total Return index and the VIX® have been licensed for use by SG in connection with the Index. S&P
shall have no liability for any errors or omissions in calculating the Index.
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