Options on Variance Swaps
Jan 26, 2005
It was rumored that some of the hedge funds in the City and in the States were shorting volatility about a year back. We were told, by our associates and friends there that though the volatility levels had fallen from their highs of post September 11, some hedge funds still believed that implied volatility vols, as measured by the VIX was high enough to warrant a short position; the view was that the volatility would fall in the coming months and the next year. More interestingly, and perhaps more importantly, some hedge funds believed that the volatility would rise for a few months to reach some kind of a local high and then start its downward spiral.
It is now well established that the volatilities have fallen from the last years levels and a lot of experts are talking a era of low volatility, whereby the implication is that the implied vols will remain low or go even lower in the coming years. While, we have difficulty sharing this view, though this scenario is quite likely, we believe it is worth while to have a look at the most exotic product that some hedge funds used a year back to short volatility.
The hedge funds were using S&P 500 variance swaps as a method for shorting volatility. They were trading options on variance swaps to take a short position in the underlying volatility.
Pricing and trading options on variance swaps may be a bit complicated for small hedge funds and they would need to fall back on either expert quants outside or take help from their prime brokers. For example, suppose I wanted to sell someone the right to put me into a variance swap at a fixed strike. As an example: I sell a 2-month option on a 1 year swap. The buyer has the right to put me into a short variance swap at a fixed strike anytime during the next 2 months. If worthwhile to the buyer, he exercises and I am in that variance swap at that strike.
Our resident quant believes that:
- This product basically amounts to pricing the "volatility of volatility" (VVOL). As such, there would not appear to be a way to price this by arbitrage. A model/process that describes the volatility of volatility would be needed;
- The higher the volatility of volatility, the more this option is worth. Thus, since vvol is higher for shorter dated volatility, this option is more valuable if the underlying swap has a short time to expiration;
- The option itself is worth more to the extent the holder has more time to exercise it.
We think the product was interesting since hedge funds may have wanted to short volatility at higher levels and this was a means of getting paid now to potentially be short volatility at higher levels.
Also, some of our outside associates who first informed us of this product were sure of these deals because that despite the obvious hedging complications, the reasons they thought that the product had legs were firstly, the hedge funds were starting to look at it and ask dealers to price, secondly, the "vol of vol" in S&P 500 has never been higher and so banks would be able to source this "vol of vol" at a decent level and finally, sellers of the option may not be tremendously price sensitive since they were effectively getting paid now (the premium) to potential sell a variance swap at attractive levels (the strike)...
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