Certificates based on implied volatility indices open up new opportunities-
Customer profile: The product can be offered to a global investor acting in markets where a volatility index is established (e.g. Germany and America)
The past few months have seen a steady rise in the range of products which are based on implied volatility indices and therefore offer an opportunity to invest in volatility. Volatility indices are calculated by stock exchanges or banks, with the two best-known in relation to share indices being the VDAX, which measures volatility on the DAX German equity index, and the VIX, which relates to the Standard & Poor?s 500.
Volatility products raise a whole series of questions. Besides factors such as the technical feasibility and liquidity of the instruments and the purpose they serve for investors, discussion is focusing on the effect they have on portfolios? risk/reward profiles.
What is the relationship between the VDAX and DAX?
There is a negative correlation between volatility and equities (see chart 2). This means that implied volatility is a suitable instrument for diversification purposes and is regarded by many market participants as a separate investment category. The reason for this is simple: if negative information depresses a company?s profit outlook or even that of the entire equity market, efficient markets tend to reduce the valuation of that share or even of the entire market. The price therefore falls, while volatility ? reflecting the prevailing uncertainty ? rises.
Figure 1 ? Comparison of the VDAX and DAX Index
Conversely, the share price rises and the volatility falls when there is a subjective reduction in uncertainty about the future value of an investment. This is a consequence of capital market theory.
An additional characteristic is the flattening decline in implied volatility when markets are rising strongly (see chart 2). There are two reasons for this: implied volatility has a ?natural floor? of zero, and when the equity markets stage a strong rise, the threat of a trend reversal means that investors are not prepared to reduce implied volatility on a straight-line basis. When there is a rapid decline in the equity markets, subjective uncertainty ?{ and therefore implied volatility ?{ soar, because market participants rush to protect their positions (even though that is precisely when it costs them particularly dearly to do so). There is no particular premium to pay for this advantageous risk/reward profile (convexity), as volatility tends to trade flat over an extended period.
Figure 2 ? The relationship between the return on equities and implied volatility
Securitisation of implied volatility
The tradability and securitisation of volatility constitutes a major financial innovation. During the term, however, volatility products in their current form may deviate substantially from their reference indices. This price difference is due to the fact that investors do not buy at the current index level but its anticipated level in the future, at the expiration date (forward). However, volatility indices such as the VDAX or the VIX reflect the current spot volatility. So the longer the term of the volatility product, the more it may deviate from its reference index. We think this poses a major problem for existing volatility products. Investors expect as high a correlation as possible between a volatility product and its respective index, particularly during the term of the product. Current products do not (as yet) meet this demand. That said, we are already working on the next generation of volatility products, in which the certificate performance should almost perfectly mirror that of the underlying volatility index throughout the term.
Contact:
Sandra Kühner Tel.: +49/(0)69-263 56515
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