Treating volatility as an asset class

Volatility, as an asset class in its own right and as a bellwether to how the equity markets perform, has had its importance ramped up in the aftermath of this summer’s ‘market correction’. The spike in volatility reached a three year high in August, according to VIX, the Chicago Board Options Exchange’s index which measures expected short-term volatility of equity options. “Volatility as an asset class is becoming more and more important both among institutional investors and high net worth individuals,” explains Hassan Houari, head of equity derivatives structuring, Barclays Capital. “The principal reason is the strong negative correlation between the equity markets and volatility,” he says. Private banking networks seeking diversification away from equity-linked investments have started recently to eye multi-asset classes based on alternative ‘underlyings’ such as emerging market, energy, and property. But could ‘hidden’ assets such as volatility, provide a source of spice for risk-neutral structured product investors? New business In the wake of the subprime crisis, equity markets have observed a significant increase in volatility. According to Mr Houari, the impact on the volumes of structured products traded was relatively small but there has been a clear trend that investors preferred products where they actually do sell volatility. “In this sense high volatilities helped to facilitate new business,” he adds. “A typical example would be a ‘reverse convertible’ – this is bond where the investor sells a put option to the dealer. Digging further for value investors, we identified certain sub-sectors with particular high volatilities and which have underperformed – too much in their view – the broader benchmark.” Philipp Orgler, head of equity derivatives product development, Barclays Capital, believes that trading volatility is a credible alternative to the use of put options as a hedging tool by investors. “The advantage is that if the equity downside scenario doesn’t materialise there is not necessarily a loss of option premium involved,” he explains. “We definitely expect an increase in trading activity in the next year as more sophisticated derivatives, such as options on the VIX, become mainstream and we expect the widespread use of new options where the payoff is not only linked to the value of the underlying at maturity, but to the realised volatility of the underlying during the life of the trade.” One such product, the Barclays Revolver Option, controls the participation to the underlying via its realised volatility during the life of the trade. It leverages when volatility decreases and de-leverages when volatility increases. “This can also lead to a significant cheapening of the cost of the option and the capital protection,” claims Mr Orgler. Francois Peningault, head of European private banking sales, Société Générale – Corporate & Investment Banking (SGCIB), argues that for the most sophisticated private banks, volatility is already considered an asset class. In terms of products for HNW clients, he says forward starting certificates hedging are mostly used “but there is a massive demand for trackers on volatility and one can expect variance swaps to emerge. “In the private banking universe, yield enhancement solutions are very popular among investors, in other words investors are mostly selling volatility (such as on reverse convertibles and autocallables): thus this has two opposite effects in rising volatility environment: investors are negatively impacted by the mark-to-market of their existing positions but at the same time they benefit from the rise in volatility on their new investments as coupons increase.” Mr Peningault notes that part of the gain from rising volatilities can be used to purchase defensive features, such as ‘look-back’ options and therefore can bring additional value to the end-investors. As an alternative to using plain vanilla options, trading activity in investable indices such as Barclays Capital’s Voltaire index has risen in recent months. Voltaire replicates the performance of a strategy of selling short-date equity market volatility. Based on a volatility arbitrage strategy, the rationale is not to express a view on the level of volatility itself but on the “volatility risk premium”, meaning by how much implied volatility over predicts future realised volatility. “On average this risk premium has largely been positive leading to high returns for investors,” explains Mr Houari. “Immediately following the subprime crisis, the realised volatility shot up and therefore during August a negative risk premium was observed. Since the end of the summer, the situation has reversed and there is a big positive risk premium: with implied volatility levels still at high levels the subsequently realised volatility was very low. For the Voltaire strategy this means that after initial correction it is now recovering well.”