Variance swaps offer investors an effective tool to trade volatility. And they’re easier to use than options.
By Lewis Knox
March 2003
Institutional Investor Magazine
Stocks, it has been said, will fluctuate. But how much? A growing contingent of institutional investors who think they know the answer to that question are trying to make money on the flux by trading a fashionable financial instrument known as a variance swap.
The swap is a bet on the future level of volatility of an index or a single stock. The payoff on the swap depends on the difference between the implied volatility of an underlying stock or index at the outset of the contract (the “strike volatility”) and the actual, or realized, volatility through maturity.
Variance swaps have a powerful appeal for investors: They are an easier way to trade volatility than options, the instrument investors have traditionally used to bet on volatility. That’s because, as Seth Weingram, an options strategist at Deutsche Bank Securities in New York, explains, the variance swap “isolates the pure volatility bet that the client is looking for.”
Says Kevin Duggan, director of volatility strategy and trading at the C$64 billion ($42 billion) Ontario Teachers’ Pension Plan, which frequently uses the technique, “Variance swaps allow portfolio managers to take directional bets on volatilities on equity without needing to trade options.” For example, an investor who believes implied volatilities on stock index options are unsustainably high at, say, 20 percent can sell a variance swap for a notional amount of $1 million. If the actual volatility experienced by the stock index during the life of the swap turns out to be 15 percent, then the investor receives the notional amount multiplied by the difference between the square of the strike volatility (variance is the square of volatility) and the square of the realized volatility -- in this case, $17,500. (Implied volatility is the expectation for volatility built into an options price, which can be calculated using an options pricing formula such as Black-Scholes.)
When implied volatilities shot up during the late July 2002 stock market swoon, variance swap volume also surged, notes Leon Gross, head of equity derivatives research at Citigroup/Salomon Smith Barney. Until a few years ago, this activity would have occurred in the options market, because an investor who wanted to make a bet on volatility had no other choice but to buy or sell options. If he thought the implied volatility of, say, Standard & Poor’s 500 index options understated the likely future volatility of the index over the next three months, he would buy a “strangle” -- an out-of-the-money put mated with an out-of-the-money call. If the index’s volatility increased, the value of the options would also increase.
But strangles, like most everything in the derivatives market, are complicated. To protect against potential losses if the index moves too far in one direction or the other, an investor must “delta hedge” the options -- that is, trade the index to hedge out any exposure to market moves. For that reason, says Kevin O’Neill, a derivatives trader at Liberty View Capital Management, a $1 billion New Jerseybased hedge fund firm, “options are labor-intensive.”
Says Ontario’s Duggan, “If you’re right on volatility but wrong on market direction, you can still lose money.”
Then there is the timing issue. If an investor correctly bets that volatility will decline, but the market takes longer to quiet down than anticipated, his options will lose value as they near expiration. Variance swaps, though, do not experience time decay.
Another problem with options: Because of the mechanics of option pricing, as the market moves away from an option’s strike, the option premium becomes less sensitive to changes in volatility. As a result, the investor could lose exposure to volatility, even as it moves in his favor. If the investor uses a variance swap, however, he shifts the burden of hedging these exposures to the swap dealer.
As relatively new over-the-counter instruments, variance swaps have definite drawbacks. An investor trading these vehicles assumes the risk that his counterparty -- the dealer -- could default, points out Diane Garnick, global investment strategist at Boston-based State Street Global Advisors, which manages $763 billion in assets. Because the variance swaps market is still relatively illiquid, Garnick suggests, investors might find it difficult to trade out of a swap in the midst of a market shock -- precisely when they would be most eager to get out.
The notion of trading volatility dates back to the early 1970s, when economists Robert Merton, Myron Scholes, Fischer Black and Paul Samuelson published their groundbreaking theories about options pricing. “Their work helped everybody understand the concept of volatility and how to price it separately from the rest of the option or stock price,” says Garnick. When the Chicago Board Options Exchange opened for business in 1973, it provided the first organized forum for trading volatility with options.
In the 1970s and 1980s, volatility trading was dominated by dealers and fund managers specializing in options overwriting. The derivatives boom of the early 1990s, along with the rise of hedge funds, brought more players to the volatility game. F&C Management, a U.K. fund manager that runs E92 billion ($99 billion), was an early trader of volatility derivatives in the mid-1990s.
The game changed in 1998, when the Russian government debt default and the collapse of Long-Term Capital Management pushed implied volatility on three-month, at-the-money S&P 500 options to almost 44 percent, according to Deutsche Bank Securities data. Investors suddenly realized that they needed an easier, more reliable way to trade volatility. They began by trading volatility swaps, but in just a few years, the variance swap outstripped the older instrument.
“Variance swaps are more popular than volatility swaps because dealers are able to hedge variance swaps with a high degree of precision and without the need to adjust the options that hedge the swap,” explains Deutsche Bank’s Weingram. “This results in lower transaction costs and less uncertainty about the performance of the hedge, which makes dealers more aggressive in quoting variance swaps.” Work by Anthony Neuberger at the London Business School helped create the underpinnings of hedging techniques for variance swaps.
Dealers who had been short on long-dated implied volatility in 1998 -- and thus risked massive losses -- used variance swaps to cover their short positions. Dealers bought. Hedge funds, correctly betting that volatility would soon ease, sold. “This was a cleaner way, mostly for hedge funds, to express a view on volatility,” says Dean Curnutt, head of equity derivatives strategy at Banc of America Securities.
Citigroup’s Gross estimates that the size of the equity variance swap market has doubled since 1998, to about $70 million “vega” -- the profit or loss on the swaps if volatility were to change by 1 percentage point -- traded cumulatively over the past 12 months.
A recent innovation in volatility trading is the single-stock variance swap, which first appeared on the scene in late 2001. “This has really reignited the whole market, in the sense that instead of having one index in the U.S., you now have 60 underlyings that are traded,” says BofA’s Curnutt. In Europe, Citi/SSB trades all the constituents of the Dow Jones Euro Stoxx 50 index. For an investor to trade a variance swap on a stock, the markets for the shares and their options must both be liquid. The instruments are similar to equity index variance swaps, with one important exception: Their value is typically capped at 2.5 times the strike volatility, whereas index swaps usually have no cap. Thus a seller of a single-stock variance swap is protected from a catastrophic increase in volatility if a particular stock implodes.
Using single-stock variance swaps, an investor bets on the volatility of one stock or of one stock compared with another. In what is known as a dispersion trade, an investor can sell volatility on an index and buy volatility on some of the component stocks in the index. Betting that volatility on the stocks is too low relative to that of the index, the investor makes money if the correlation among all the index components increases to its normal level.
Indeed, Citigroup’s Gross suggests that a packaged version of this trade, known as a covariance or correlation swap, may represent the next step in the development of equity volatility trading: Correlation swaps would let investors make the increasingly popular dispersion bets in one trade.
What stance should a money manager now take on volatility? An investor betting on a double dip in the economy will look for a spike in volatility. “Volatility as a whole tends to be higher during recessionary periods,” says State Street’s Garnick.
Of course, an investor’s judgment on volatility will be mostly informed by his view of the potential war in Iraq. Implied and realized volatilities on the S&P 500 are well below their October 2002 highs, but news from Baghdad could change that in an instant.
