Investing in Volatility Strategies

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Investing in Volatility Strategies

An Introduction

CAIA Educational Event

Zürich, 3rd of December 2013

Dr. Daniel Hofstetter

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Investing in Volatility Strategies - An Introduction

The term «Volatility»

Established tradable Instruments Characteristics of Volatility

Common Volatility Strategies

Opportunities for Volatility Strategies Challenges

Summary

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General information

− Latin: Volatilis - flying/volatile

− In general a measurement for the fluctuation of a certain parameter

Financial and capital markets

− Measurement for the fluctuation of financial parameters (prices, interest rates, etc.)

− Defined as standard deviation

− Serves for the assessment of risk (risk measure)

− Historic or realized volatility

− Standard deviation of time series from financial parameters

− Mostly used regarding rates of return

− Ex post calculation

− Implied volatility

− Derived from market prices of options on underlying assets

− Standard deviation of the underlying rate of return (random variable) contained in option prices

implied

− Ex ante measurement that reflects the current expected variation of the base value

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The term «Volatility»

©2013 IFR Institute for Financial Research 4

92 94 96 98 100 102 104 106 In v e s tm e n t V a lu e

Past Today Future

Historic/realized Volatility

Future implied Volatility Current implied Volatility

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Established tradable instruments

Futures on implied volatility

− Futures on the implied volatility that captures the 30 days forward looking implied volatility on the

futures’ expiration date (standardized p.a.)

− Implied volatility reflects the standard deviation of the underlying rate of returns (random variable)

contained in option prices implied

− Markets: S&P 500/VIX, STOXX 50/VSTOXX, NIKKEI 225/VNKY

VIX index

− Currently embedded 30 day implied volatility in S&P 500 options (standardized p.a.)

− Non tradable

Further instruments (implied vs. realized volatility)

− Variance Swap

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Characteristics of Volatility

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Characteristics of implied volatility

− Strong negative correlation with stocks

− Mostly low implied volatility during positive stock

markets periods

− Negative to very low correlation with commodities

and bonds

− Persistent characteristics

Comment

− S&P 500 VIX Mid-Term Futures Index TR:

− Investable

− Same roll mechanism as for the well known

VIX-ETN of iPath (VXX, VXZ, …)

− Correlation characteristics with stocks,

commodities and bond also consistent with

investable VIX Futures implementations (instead of VIX Index) 0 20 40 60 80 100 120 140 160 180 200 220 240 -60 -20 20 60 100 140 180 220 260 300 Im p lie d V o la ti lit y ( % /r h s ) V a lu e ( U S D /l h s ) Development Daily Data

S&P 500 TR (lhs) S&P 500 VIX Mid-Term Futures Index TR (lhs) VIX Index (rhs)

Source: Bloomberg, own Calculations

-1.00 -0.75 -0.50 -0.25 0.00 0.25 0.50 0.75 1.00 C o rr e la ti o n

Rolling Correlations (3 Months // USD)

Daily Data

VIX Index vs. S&P 500 TR VIX Index vs. DJ UBS Commodity TR Index VIX Index vs. JPM Global Aggregate Index

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Characteristics of Volatility

Further characteristics of implied volatility

− Sudden spikes

− In connection with stock market crashes

− Typically high in magnitude

− Grey ellipses

− Mean reverting

− Normalization over a determined period of time

− Persistent characteristics

Comment

− S&P 500 VIX Short or Mid-Term Futures

Index TR:

− Investable

− Same roll mechanism as for the well known

VIX-ETN of iPath (VXX, VXZ, …) 0 20 40 60 80 100 120 140 160 180 200 220 -150 -100 -50 0 50 100 150 200 250 300 350 Im p lie d V o la ti lit y ( % /r h s ) V a lu e ( U S D /l h s ) Development Daily Data

S&P 500 VIX Short-Term Futures Index TR (lhs) S&P 500 VIX Mid-Term Futures Index TR (lhs) VIX Index (rhs) VIX Futures 1st Contract (rhs)

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Characteristics of Volatility

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Characteristics of the futures curve

− Mainly in contango

− Usually generating rollover losses

− Variations significantly bigger at the short end

than at the long end

-32 -24 -16 -8 0 8 D if fe re n c e ( % -P o in ts )

Development of Contango and Backwardation

Daily Data

Difference (VIX Futures 2nd Contract minus VIX Futures 1st Contract) Difference (VIX Futures 6th Contract minus VIX Futures 1st Contract)

Source: Bloomberg, own Calculations

10 15 20 25 30 35 0 1 2 3 4 5 6 F u tu re s P ri c e ( % /i m p lie d V o la ti lit y ) Contract

Contango and Backwardation

Backwardation Contango H ig h F lu c tu a ti o n Low Fluctuation

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Characteristics of Volatility

Characteristics of implied vs. realized volatility

− Implied volatility generally higher than realized

volatility

− Inversion combined with spikes

0 10 20 30 40 50 60 70 80 90 V o la ti lit y ( % )

Implied Volatility vs. realized Volatility Daily Data

VIX Index (shifted by 30 days) S&P 500 TR

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Common Volatility Strategies

©2013 IFR Institute for Financial Research 10

1. Hedging of Stock Positions with Volatility Futures

Target • Hedging of stock positions

• Benefit from the strong negative correlation between

implied volatility of stocks and stocks itself

Mechanism • Buying of implied volatility via futures

• Partially including a signal for exposure adjustments

• S&P 500, STOXX 50, NIKKEI 225, …

Challenge • Over long periods high rollover costs for futures

( see next slide)

Comments • Emerged after stock market crash in 2008

• Known implementation: ETF «VXX US» (iPATH S&P

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Common Volatility Strategies

Challenge of pure hedging strategies

− Simple long VIX futures strategies

− High rollover costs over longer periods

Comment

− iPATH S&P 500 VIX Short-Term Futures ETN

− Passive ETN on long short-term VIX futures

− Also known as VXX US

− S&P 500 VIX Mid-Term Futures Index TR

− Investable

− Same roll mechanism as for the well known

VIX-ETN of iPath (VXX, VXZ, …) -20 0 20 40 60 80 100 120 V a lu e ( U S D ) Development Daily Data

iPATH S&P 500 VIX Short-Term Futures ETN (VXX) S&P 500 VIX Mid-Term Futures Index TR VIX Investment 1st Contract

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Common Volatility Strategies

©2013 IFR Institute for Financial Research 12

2. Carry Strategy

Target • Capitalize on primarily negative rollover effects

• Collecting carry

Mechanism • Selling of implied volatility via futures

• Partially including a signal for exposure adjustments

• S&P 500, STOXX 50, NIKKEI 225, …

Challenge • Risk of spikes in implied volatility

− Increasing price of futures contract

− Losses due to the repurchase (unwind) of the

futures contract

• Ongoing small earnings are suddenly facing great

losses

Comments • Other side (short side) in trading implied volatility

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Common Volatility Strategies

3. Combination Strategy (Combination of Hedging and Carry)

Target • Linking the advantage of Hedging (protection) and

Carry (current earnings)

• Mitigation of respective problems Hedging (rollover

costs) and carry (implied volatility spikes)

Mechanism • Adjustment of weights whether to force hedging or

carry techniques

• Decision based on signals/algorithms

• Buying and selling of implied volatility via futures

• S&P 500, STOXX 50, NIKKEI 225, …

Challenge • Product diversity

• Different levels of maturity regarding mechanisms

Comments • Example of signals

− Shape of the futures curve

− Volatility of volatility

− Momentum of volatility

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Common Volatility Strategies

©2013 IFR Institute for Financial Research 14

4. Risk premium strategy

Target • Capitalize on primarily positive premiums between implied

vs. realized volatility

• Collecting risk premiums

Mechanism • Basically selling of implied volatility and buying of realized

volatility

• Variants

− A: Short selling of options and regular delta hedging

− B: Selling of Variance SWAP

• S&P 500, STOXX 50, NIKKEI 225, ...

Challenge • Risk of spikes in realized volatility

− Cost increases in realized volatility

− Delta Hedging costs more (Variant A)

− Variance Swap becomes more expensive (Variant B)

• Normally, mitigate risk by weight adjustment based on

signals/algorithms

• High (Low) spike potential triggers an exposure reduction

(increase)

Comments • Mostly lower risk compared to combination strategies

• Example of a signal: recent realized volatility vs. implied

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Common Volatility Strategies

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Common Volatility Strategies

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Characteristics of the strategies

− High return potential throughout different market

periods

− Mean reverting around a positive Trend

− Partially not correlated with each other

− Mostly not correlated with traditional investments

− Drawdowns can be large

Conclusion

− Existence of different and diverse volatility

strategies

− No clear definition of a volatility investment

− Diversification across a variety of strategies/

sources of return is appropriate

− Useful diversification to a traditional portfolio

0 200 400 600 800 1'000 1'200 1'400 1'600 1'800 V a lu e ( U S D )

Return Comparison of Example Strategies Weekly Data

Strategy Combi A Strategy Combi B Strategy Risk Premium A Strategy Risk Premium B

Source: Bloomberg, Provider, PackHedge, own Calculations Different inital values, hence the same

scale can be used

-50 -40 -30 -20 -10 0 D ra w d o w n ( % )

Drawdown Example Strategies (USD)

Weekly Data

Strategy Combi A Strategy Combi B Strategy Risk Premium A Strategy Risk Premium B

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Opportunities for Volatility Strategies

Extension of a balanced mandate with a volatility portfolio

− Positive influence on the balanced portfolio across

different market periods

− Reduced drawdowns as in 2008

− Better performance

Comparison with traditional asset categories

− Return potential

− High during different market periods

− Especially high in long lasting negative stock

markets

− Mostly uncorrelated

− Low drawdowns

---Explanation

− Portfolio «Balanced international 40/60»

80 90 100 110 120 130 140 150 160 V a lu e ( U S D ) Extension (Backtesting) Weekley Data

Balanced international incl. 10% Vola-Portfolio (general / backtesting / net) Balanced international 40/60

Source: Bloomberg, Provider, PackHedge, own Calculations

80 100 120 140 160 180 200 V a lu e ( U S D )

Comparison to traditional Asset Classes (Backtesting)

Weekly Data

Different inital values, hence the same scale can be used

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Challenges

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Challenges

− Many similar strategies

− Normally, the backtesting is very good

− Risk management mechanisms or allocation

signals are partly missing

− Partly single focus on a particular market period

Answer see slide after next slide

Example: Single focus (charts)

− Upper chart

− Strategy yields good results during spikes

(grey ellipses)

− Lower chart

− Initially confirmation of expectation (good

covering of spikes First 50 weeks of green

line)

− Overall weak after spikes (grey ellipses)

− Especially after week 261

− Focus not enough diversified

80 100 120 140 160 180 200 220 240 260 280 300 320 V a lu e ( U S D ) Week

Example: Single Focus

Weekly Data

Example Strategy A

Source: Bloomberg, Provider, PackHedge, own Calculations

80 100 120 140 160 180 200 220 240 260 280 300 320 V a lu e ( U S D ) Week

Example: Single Focus

Weekly Data

Example Strategy A

Source: Bloomberg, Provider, PackHedge, own Calculations

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Challenges

Challenges (cont.)

− Even mature programs can face difficulties

Answer see next slide

Example: Changing market environment (charts)

− Upper chart

− Accumulation of large drawdowns (-12% and

higher) and fast recoveries (grey ellipse)

− Even stronger on a daily basis

− Lower chart

− Explanation: VIX Index for a long time below

18% Higher percentage change of VIX per

one unit of volatility (grey ellipse)

− Consequence: Modification of strategy

allocation mechanism by the manager

-100 0 100 200 300 400 500 600 700 V a lu e ( U S D ) Week

Example: Changing Market Environment

Weekly Data

Example Strategy B

Source: Bloomberg, Provider, PackHedge, own Calculations

30 40 50 60 70 80 90 100 110 120 100 200 300 400 500 600 700 Im p lie d V o la ti lit y ( % /r h s ) V a lu e ( U S D /l h s )

Example: Changing Market Environment

Weekly Data

Source: Bloomberg, Provider, PackHedge, own Calculations

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Challenges - Answers

20 Severe Selection of the Strategies Focus on Allocation Mechanism Diversification across several Strategies Proper Risk Management of the Strategies Controlling of Market Environment

Crucial

Elements for a

Volatility

Portfolio

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Summary

Summary

− Interesting, own asset category

− High potential as a diversifying source of return

− No clear investment in volatility but several volatility sources of return

− Volatility strategies with pros and cons

− Essential for investing in volatility strategies is

− Selection of strategies Sound analyses of allocation mechanism

− Diversification

− Proper risk management

− Controlling of market environment

Contact

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Die Informationen in dieser Präsentation sind Eigentum der IFR AG und dürfen ohne schriftliche Einwilligung derselben nicht weiter verwendet werden. Bei der Erarbeitung hat IFR die übliche Sorgfalt angewendet, übernimmt aber keinerlei Haftung für die Vollständigkeit, Richtigkeit und Aktualität der Daten und

Auswertungen. Die Darstellungen dienen ausschliesslich der Informationsversorgung und der

Meinungsbildung. Ein möglicher Investor ist auf jeden Fall gehalten, sich im Rahmen seiner Erwägungen für einen Investitionsentscheid seine eigenen, gesamtheitlichen Überlegungen und Einschätzungen zum Anlagethema sowie zu seiner Risikofähigkeit und Risikobereitschaft anzustellen. Die historische Performance ist kein Garant für die künftige Performance.

Disclaimer

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References

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