Volatility Futures at Eurex

Axel Vischer

Eurex Business Development Equity & Index Derivatives November 2006

Agenda
n

Trading Volatility: Available Instruments and Concepts Volatility Futures: Trading Volatility made easy Basics on Futures Pricing Applications

Realized vs. Implied Volatility

n

Realized Volatility
Also referred to as historical volatility Based on historical market data, e.g. prices observed in the past Standard deviation of a stocks or indexs returns over the last N days Return: natural logarithm of close-to-close price observations

Implied Volatility
Implied by observed option prices Iterative numerical procedure needed to extract implied volatility out of option prices Forward looking: markets opinion about the expected volatility of the stock or index

Most of the time implied volatility is larger than realized volatility

The difference is the risk premium payable to the holder of the short volatility position.

Different types of measuring & trading Vola

(Brief History)
1993 1994 1996 1997 1998 Introduction of VIX index at CBOE Introduction of VDAX at Deutsche Brse (Realized) Vola Futures by OMX Introduction of VDAX real-time + Sub-indices - Volax-Future at DTB (today Eurex) - First Volatility & Variance Swaps in the OTC market - VIX Future at the CBOE listed since March 2004 - Variance Future at the CBOE - Introduction of Volatility indices VDAX-New, VSTOXX & VSMI - Volatility-Futures on VDAX-New, VSTOXX, VSMI at Eurex
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2004

2005

Trading Volatility OTC (1/2)

n

Volatility Swaps Contract on forward realized volatility Payoff = Notional * ( realized volatility volatility strike ) = N * (v-Dvol) Variance Swaps Contract on forward realized variance Payoff = Notional * ( realized volatility2 variance strike ) = N * (2v-Dvar) = is the actual volatility of an index over the life of the contract, = the volatility specified by the swap, = the notional amount of the swap (in dollar, euro, etc.) per a unit of volatility.

where: v Dvol N

The fair value of a Volatility / Variance swap is the volatility/variance strike that makes the swap have zero value at inception.

Trading Volatility OTC (2/2)

Volatility Swap - Linear Payoff - Gain for swap owner from 20% volatility increase ~ Loss from 20% decrease - Dynamic hedge - Market Volume pretty small

Variance Swap - Non-linear Payoff - Gain for swap owner from 20% volatility increase > Loss from 20% decrease - Static hedge - estim. Market vol. in Europe > 80 bn EUR p.a. 6

Hedging
Static Hedge:
Hedge is implemented in an initial transaction No more adjustments necessary afterwards Hedged position is insensitive to market changes Preferred procedure for all hedgers

Dynamic Hedge:
Hedge is implemented in an initial transaction Frequent adjustments necessary afterwards Hedged position is sensitive to market changes Frequency of readjustments can be regular or irregular, but generally driven by market changes The more readjustments the hedger has to perform during the life-time of the hedged position, the more expensive and inconvenient the dynamic hedging procedure is

Agenda
n

Trading Volatility: Available Instruments and Concepts Volatility Futures: Trading Volatility made easy Basics on Futures Pricing Applications

Index Design: Link between Index and Future

Index concept and design need to anticipate demands from the users of volatility futures: Issues facing derivative user Ability to Hedge Index Must represent Volatility Buy-Side Investor Derivative Market Participant Market Maker / Issuers of structured products

Index Design
n n

Implied ATM Vola

n n n n

Methodology established: VDAX, VXO (old VIX) Calculation method complicated (implied volatilities necessary) Based upon a limited number of near ATM option prices Derivative would need to be hedged dynamically In terms of hedging worst case scenario OTC Swap Market negligible

Implied Variance

n n n n n

Stable and straightforward formula for evaluation using option prices directly not implied volatilities More representative (using a strip of options) Static hedge possible Swap market well established Is NOT and does NOT look like volatility.

Square Root of Implied Variance

n n n n

Stable and straightforward formula for evaluation using options directly not implied volatilities More representative (using a strip of options) Can only be hedged dynamically Is closely related to implied volatility but not identical. The information about the full skew is contained in the strips of options. 10

Volatility Indices: Methodology

n

Evaluation of Sub-index per option expiry based on the square-root of implied variance
100 times the square root of 2 The first 8 expirations are covered by sub-indices

All sub-indices are calculated real time

Update frequency of 1 minute

Construction of rolling index at 30 days to expiration through linear interpolation of the two nearest sub-indices Index formula represents the fair strike for a variance swap to a given expiry.
K 2 1 F = 2j R M ( K j ) 1 T j Kj T K 0
2 2

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Volatility Levels %
15 25 35 45 55 65 75

03.01.2000 03.04.2000 03.07.2000 03.10.2000 03.01.2001 03.04.2001 03.07.2001 03.10.2001 03.01.2002 03.04.2002 03.07.2002 03.10.2002 03.01.2003 03.04.2003 03.07.2003 03.10.2003 03.01.2004 03.04.2004 03.07.2004 03.10.2004 03.01.2005 03.04.2005 03.07.2005 03.10.2005 03.01.2006

Volatility Indices: Comparison

VDAX-NEW VSMI VSTOXX

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Volatility Futures: Contract Specs

n n

Underlying: Volatility Index VSTOXX (for FVSX), VDAX-NEW (for FVDX) and VSMI (for FVSM) Contract Value: EUR1000 per index point (FVSX, FVDX), CHF 1000 per index point (FVSM) The vega of the contract Minimum Price Movement: 0.05 of a point, equivalent to a value of EUR 50 and CHF 50 respectively Typical minimum tick size in variance swap market is 0.10 points Last Trading Day: The Wednesday prior to the second last Friday of the expiring month (exactly 30 days before the next index option expiry, no index interpolation necessary) Contract Months: The three nearest calendar months and the next quarterly month of the February, May, August, and November cycle Daily Settlement: The closing price determined within the closing auction; If no price can be determined in the closing auction or if the price so determined does not reasonably reflect current market conditions, daily settlement price will be the last traded price within the last 15 minutes of Continuous Trading. If the last traded price is older than 15 minutes or does not reasonably reflect current market conditions, Eurex will establish the official settlement price. Final Settlement: Cash settled Final Settlement Price: Average over the index ticks of the last 30 minutes before expiration (FVSX: 11:30-12:00 CET, FVDX: 12:30-13:00 CET). Exception for FVSM, average over last 60 minutes: 9:00-10:00 CET. Trading hours: 09:00 a.m. until 17:30 p.m. CET

n n

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Volatility Futures: Designated Market Making

n n

Minimum contract Size: Maximum Spread: Required Coverage: Expiry Range: Incentive:

10 contracts 10% of bid price, i.e. Future bid = 17%, spread 1.7 points 85 percent of the total trading period on a monthly average All 4 available expirations have to be covered 100%-fee rebate until 31st of March, 2007, for fulfilling the monthly obligations Merrill Lynch Optiver Currently all maturities are quoted with spreads of around 0.5 volatility point

n n n

Current Market Makers:

Typical Spreads:

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Agenda
n

Trading Volatility: Available Instruments and Concepts Volatility Futures: Trading Volatility made easy Basics on Futures Pricing Applications

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Implied Volatility Term Structure

22 VDAX-NEW VSTOXX VSMI 20

(as of Oct. 17th)

18

16

14

12

10 Oct 05 Nov 05 Dec 05 Mar 06 Jun 06 Sep 06 Dec 06 Jun 07

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Arbitrage Bounds for Futures price

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Variance is additive:

Mathematically, due to the so-called convexity bias, this approach gives us an upper bound for the fair value One can show that a corresponding lower bound can be calculated by the forward vola swap rate

Lower bound

Fair Value

Upper bound

E RVT1 ,T2 E E (RVT1 ,T2 ) E(RVT1 ,T2 )

calculated via imp. Forward vola swap curve approx. by ATM vola (e.g. old VDAX subind.) calculated via imp. Forward variance swap curve approx. by vola (e.g. VDAX-New subindices)
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Fair Future Values

VSTOXX Subindices
3 d.

(example: VSTOXX, Oct. 17th 2005)

18.88
31 d.

16.50
59 d.

16.63
150 d.

17.17

interpolated Subindices

1 d.

19.05
29 d.

16.67
64 d.

16.66
120 d.

16.99

30.d

16.41
30.d

Upper bounds

16.59
30.d

(~ 16.9)
30.d

17.88 17.Mar 18

16.Nov

18.Nov

16.Dec

21.Dec

15.Feb

20.Jan

17.Oct

19.Oct

21.Oct

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Fair Future Values

12

14

16

18

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How good are the bounds?

Vola-Futures FVDX (OCT 05)

Upper Bound Settlement Price Lower Bound

.0 9 20 .20 . 0 05 9 21 . 20 .0 05 9 22 .20 .0 05 9 23 .20 . 0 05 9 24 . 20 .0 05 9 25 .20 .0 05 9 26 .20 . 0 05 9 27 . 20 .0 05 9 28 .20 .0 05 9 29 .20 . 0 05 9 30 . 20 .0 05 9 01 .20 .1 05 0 02 .20 . 1 05 0 03 . 20 .1 05 0 04 .20 .1 05 0 05 .20 . 1 05 0 06 . 20 .1 05 0 07 .20 .1 05 0 08 .20 . 1 05 0 09 . 20 .1 05 0 10 .20 .1 05 0 11 .20 . 1 05 0 12 . 20 .1 05 0 13 .20 .1 05 0 14 . 20 . 1 05 0 15 . 20 .1 05 0 16 .20 .1 05 0 17 .20 . 1 05 0 18 . 20 .1 05 0 19 .20 .1 05 0 20 .20 . 1 05 0 21 . 20 .1 05 0. 20 05

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14

15

16

17

18

19

20

20

Fair Values for the different expiries

Daily Settlement Prices for FVDX

FV2 FV4

FV1

.0 9. 2 .0 005 9 21 .20 .0 05 9. 22 20 . 0 05 9 23 . 20 . 0 05 9 24 . 20 .0 05 9 25 .20 .0 05 9 26 .20 . 0 05 9 27 . 20 . 0 05 9 28 . 20 .0 05 9 29 .20 .0 05 9 30 .20 .0 05 9 01 .20 . 1 05 0 02 . 20 .1 05 0 03 .20 .1 05 0 04 .20 .1 05 0 05 . 20 . 1 05 0 06 . 20 .1 05 0 07 .20 .1 05 0 08 .20 .1 05 0 09 . 20 . 1 05 0 10 . 20 .1 05 0 11 .20 .1 05 0. 12 20 . 1 05 0 13 . 20 . 1 05 0 14 . 20 . 1 05 0 15 .20 .1 05 0 16 .20 .1 05 0 17 .20 . 1 05 0 18 . 20 .1 05 0 19 .20 .1 05 0 20 .20 .1 05 0 21 .20 . 1 05 0. 20 05

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Price Comparison
FVSX FVDX FVSM

Currency Euro Euro CHF

Order Book 0.50 0.75 1.20

Block Trades 0.75 1.10 1.80

Compare Vegas for a 1% Volatility change between volatility futures and their underlying index options
Measure about how much cheaper the new volatility futures are to build up pure vega positions

VSTOXX future
A 1% volatility increase/decrease changes the contract value by +/- 1000 EUR (vega)

ATM-options on the EURO STOXX 50 index

Vega ~ M S T / 100 ~ 95 EUR Mmultiplier (10 EUR/index point) Tannualized time to maturity ( e.g. 1month: T = (1/12) ) Sunderlying index level (e.g. around 3300 index points)

About at least 10 ATM EURO STOXX 50 Index options are needed to provide the same vega as the VSTOXX future
VSTOXX contract fee: 0.5 EUR Euro Stoxx 50 index options contract fees: A- account (customer): 0.3 EURreplication cost: 3 EUR

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Risk Management
n n n

Only vega exposure (sensitivity to volatility), no delta exposure (sensitivity to underlying cash index) Vega exposure is constant over time
Vega of a variance swap declines linearly over time and is zero at settlement of the contract

Value at risk can be based on the sensitivity to changes in volatility

VSTOXX Index Weekly Returns 2000-2005
22

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Frequency

12

7
VAR

2
-25 -23 -21 -19 -17 -15 -13 -11 -9 -7 -5 -3 -1 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

-3 Return in %

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Hedge Ratio
n

Negative correlation between volatility and the underlying cash index

E.g. a 1% fall in the EURO STOXX 50 level triggers roughly a 2.6% rise in the VSTOXX E.g. a 1% fall in the Euro STOXX 50 level costs 1 Mio. Euro

n n n

Goal: Hedge a 100 Mio. Euro Euro STOXX 50 index exposure

The VSTOXX future delivers a 1000 Euro Vega exposure Hedge Ratio VSTOXX vs. EuroStoxx
1 Mio. Euro / 2.6 / 1000 Euro = 385 Futures
VST O XX Re tu rn in % 50 40 30 20 10 0 -10 -20 -30 -40 -50 -15
based on weekly returns 2000-2005

Regression: Y = -0.5 -2.6 * X

-10

-5

10

15

Euro STOXX Return in %

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Agenda
n

Trading Volatility: Available Instruments and Concepts Volatility Futures: Trading Volatility made easy Basics on Futures Pricing Applications

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Uses for Volatility Futures (I)

n Hedge

equity market exposure: crash risk: correlation exposure: credit spread exposure:

- equity returns and volatility changes are negatively correlated.

Hedging

n Hedge n Hedge n Hedge

- volatility rises significantly and rapidly in a crash scenario. - e.g. stock-picking becomes harder in a high correlation environment. - volatility and credit spreads are linked.

Spread Trading

n Trading n Trading

Market Spreads Calendar Spreads

- e.g. Volatility spread between US (VIX) and Europe (VSTOXX) - Trading on changes in the volatility term strucuture

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Uses for Volatility Futures (II)

Speculating
n Invest

in volatility as an asset class in itself: asset allocation:

- volatility can improve the risk and return characteristics of a balanced portfolio.
n Tactical n Take

- e.g. volatility can be a key input and risk in the asset allocation process.

outright views on volatility:

- e.g. volatility tends to be mean-reverting, speculators can take advantage of this characteristic.

Arbitrage

n Volatility

arbitrage:

- trade implied versus realized volatility - trade Volatility futures against a delta-neutral portfolio of options

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Further Information
n

At the institutional investor section of www.eurexchange.com further information is available, e.g.,

Thesis: Volatility and its Measurements: The Design of a Volatility Index and the Evaluation of its Historical Time Series at the Deutsche Brse AG Various papers on derivatives in alternative investment from Edhec Business School and Tom Schneeweiss, CISDM

For further questions please send an e-mail to

Axel.Vischer@eurexchange.com Investors@eurexchange.com

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