Variance Swaps For Pension Portfolio

VARIANCE SWAPS IN A
PENSION FUND PORTFOLIO
University of Maastricht
Faculty of Economics and Business Administration
Maastricht, August 31, 2007
Ivo Neuerburg, i196010
Master Thesis Financial Economics
Supervisor: Dr. Tom van Veen
Second supervisor: Dr. Olaf Sleijpen
EXECUTIVE SUMMARY
This paper examines the added value of variance swaps to a pension fund portfolio. Variance
swap properties will be investigated from different angles. First of all, a strategic long or short
position is assumed using historic data. But also more dynamic trading strategies are used,
which base their position on the prevailing market conditions. Secondly, an Asset-Liability
Management (ALM) analysis is performed, to study the interaction between the return on
variance swaps and the liabilities of a pension fund.
Volatility risk where volatility is defined as the standard deviation of log returns - is a risk
that, until recently, was hard to hedge. However, most investors face high volatility risks.
These risks range from an increase in tracking error for an investor following a benchmark, to
higher transaction costs due to more frequent rebalancing of a portfolio. Holding a
combination of options such as straddles, strangles, strips and straps was the method used to
attain a hedge against market shocks. However, these option constructions require constant
rebalancing to hedge away all the delta risks and avoid any exposure to the asset price itself.
Volatility and variance swaps were therefore constructed to provide a pure exposure to the
volatility of a single stock or stock index. A swap is a contract which obliges the holders to
exchange cash flows. The buyer of the contract pays a fixed, pre-set rate (the implied
volatility), while receiving a floating rate based on the realized volatility over the maturity of
the contract. This way, any investor can hedge away his or her volatility risk. On top of this,
due to the strong negative correlation between volatility and equity returns, these swaps also
provide a hedge against stock market crashes. A variance swap is the same as a volatility
swap, only that it is based on the variance of the underlying asset; variance being volatility
squared. In this paper, variance swaps with a maturity of 1 or 3 months will be examined.
Throughout this paper the profitability, diversification benefits, and hedging qualities of
variance swaps will be explored. Firstly, a historical, asset-only analysis will be performed.
For this analysis 17 years of data is used, ranging from 1990 to 2007. It is concluded that a
strategic long position in variance swaps is very costly and does not provide the expected risk
mitigating benefits. On the other hand, a short position provides a good return and is less risky
than anticipated. Furthermore, it is shown that a dynamic trading strategy using market signals
for buying or selling variance can enhance the returns without taking on extra risk.
Since pension funds are not asset-only investors, but also have to keep their liabilities in mind,
an ALM study is performed. Again, it is concluded that buying variance swaps is not the best
investment, yielding negative returns and not decreasing generally accepted risk factors.
Going short (selling) seems to be very profitable and with respect to the liabilities not very
risky. These results could have been expected as being short is the simple opposite of a long
position. Furthermore, some dynamic strategies are investigated. It turns out that by timing
the investment, variance swaps can yield even better results outside the strategic portfolio.
Variance swaps in a pension fund portfolio
Table of Contents
TABLE OF CONTENTS
1.
INTRODUCTION ..................................................................................................................................- 2 -
2.
VOLATILITY ........................................................................................................................................- 5 2.1.
3.
VOLATILITY INVESTMENT USING OPTIONS ...................................................................................... - 6 -
VOLATILITY SWAPS...........................................................................................................................- 9 3.1.

3.2.
3.2.1.
3.3.
3.4.
4.
BASIC SWAPS ................................................................................................................................... - 9 VARIANCE AND VOLATILITY SWAPS ............................................................................................... - 11 Payoff structure.........................................................................................................................- 11 VOLATILITY VS. VARIANCE SWAPS................................................................................................. - 14 PRACTICAL APPLICATIONS OF VARIANCE SWAPS ........................................................................... - 15 -
METHODOLOGY............................................................................................................................... - 17 4.1.
4.2.
4.3.
4.4.
VIX ............................................................................................................................................... - 17 NOTIONAL AMOUNT ....................................................................................................................... - 19 REALISED VARIANCE ..................................................................................................................... - 19 YIELD ............................................................................................................................................ - 19 -
5.
DATA..................................................................................................................................................... - 20 -
6.
RESULTS.............................................................................................................................................. - 20 6.1.
BASIC INDICATORS LONG AND SHORT STRATEGY .......................................................................... - 21 6.1.1.
Strategic investment (Strategy I & II) ......................................................................................- 22 6.1.2.
Correlations .............................................................................................................................- 24 6.2.
DYNAMIC TRADING ........................................................................................................................ - 27 6.2.1.
Strategy III ...............................................................................................................................- 28 6.2.2.
Strategy IV................................................................................................................................- 29 6.2.3.
Strategy V .................................................................................................................................- 30 -
7.
ASSET-LIABILITY MANAGEMENT .............................................................................................. - 31 7.1.

7.2.
7.2.1.
7.3.
7.4.
8.
MARKOWITZ PORTFOLIO OPTIMIZATION ........................................................................................ - 31 ASSET-LIABILITY MANAGEMENT ................................................................................................... - 32 The basic idea behind ALM......................................................................................................- 32 FAIR VALUE ................................................................................................................................... - 34 LIABILITY RISKS............................................................................................................................. - 34 -
ALM RESULTS ................................................................................................................................... - 37 8.1.

8.2.
8.3.
8.4
STRATEGIC INVESTMENT PLAN (STIP) .......................................................................................... - 38 ALM OUTPUT EXPLAINED ............................................................................................................. - 38 STRATEGIC INVESTMENT (STRATEGY I & II) .................................................................................. - 39 DYNAMIC TRADING STRATEGIES .................................................................................................... - 43 -
9.
FUTURE RESEARCH ........................................................................................................................ - 50 -
10.
CONCLUSION..................................................................................................................................... - 53 -
11.
REFERENCES ..................................................................................................................................... - 55 -
12.A.
HISTORICAL PERFORMANCE OF ALL STRATEGIES................................................... - 58 -
12.B.
SCATTER PLOTS & HISTOGRAMS..................................................................................... - 59 -
-1-
1.
Introduction
INTRODUCTION
Over the past years, the financial sector has been very creative in inventing new investment
vehicles. Apart from the rise in relatively new asset classes such as private equity, hedge
funds and infrastructure, there has also been a steady growth of derivative products.
Derivative products have no intrinsic value, but instead their value is dependent on the value
of an underlying asset, which can be almost anything from stocks to cattle. Nowadays, there
exist derivatives ranging from simple call-options to complicated swaptions or even weatherdependent products. The growth of derivatives has increased the spectrum of investment
possibilities, providing new speculation possibilities to investors. Since derivatives are
dependent on other assets, they can be used as a hedge too. Although options have always
been a popular tool to hedge stock returns (delta risk), their hedging strength is limited as will
be shown. However, as Neuberger (1994) finds, after delta-risk, volatility risk is the second
largest risk factor for most banks and investors. Therefore it will not come as a surprise that
one of the recent innovations has been the introduction of volatility related products. The
payoff of these products is solely related to the expected and/or realized volatility of the
underlying asset. Generally, the underlying asset is a stock index, although volatility
derivatives based on individual stocks are gaining popularity.
Since this is a fairly new asset class, not much research has been done regarding the benefits
of investing in volatility. However, there is some literature showing that volatility derivatives
indeed have beneficial characteristics in an investment portfolio. For instance, Whaley (1993)
finds that volatility derivatives are an easier and, more importantly, cheaper method of
hedging a portfolio than using options. Furthermore, Lighaam (2006) finds that the inclusion
of variance swaps as an overlay to the portfolio of pension funds can have beneficial effects
on the efficient frontier which are larger than using put options. Non-academic research
provided by financial institutions, also indicates that variance swaps provide a better and
cheaper method of hedging volatility exposure than a strip of options does. For instance,
Hosker and Dholakia, (2004) show that a combination of 11 options underperforms compared
with variance swap. This underperformance ranges from 15 percent in a low volatility
climate, up to 27% in a high volatility climate. Unfortunately it is not all good, as for instance
-2-
Introduction
Wallmeier & Hafner (2006) find that variance swap returns can be as low as -30% per month
for a long variance swap on the German index DAX. Carr & Wu (2004), Bondarenko (2004)
and Bakshi & Kapadia (2003) all find that variance risk premiums are significant and strongly
negative. Leippold, Egloff & Wu (2006) show that access to the variance swap market can
significantly enhance the returns of an investment portfolio. In this paper an attempt is made
to shed more light on the possibilities of volatility investments, and the investment
opportunities this new asset class gives.
In order to find an answer to the question how volatility derivatives can be used in a (pension
funds) portfolio, the focus will lie on variance swaps. The reason why this variance swaps are
the centre of attention is two-fold. First of all, the variance swap market is growing rapidly,
and variance swaps seem to be a popular product. The other reason is more practical. Using
the Volatility Index (VIX) as a proxy for the implied volatility provides data over the past 17
years. For products such as volatility futures and volatility options, available data series are
simply not long enough to draw reliable conclusions. Another practical advantage is that by
using the S&P 500 as a benchmark for equity returns, the majority of stock return volatility is
captured. Naturally, there are some differences between equity markets worldwide, but on
average they tend to behave quite similar. In bond or real estate markets, returns are more
idiosyncratic and it will be harder to trade on volatility with just one simple tool.
To find out if and how variance swaps are good investments, the risk-return characteristics
need to be examined. It is assumed that every month there are three possibilities to choose
from: buy, sell or do nothing. Firstly, the historical performance of long and short positions
will be analysed. It will be concluded that the premium paid to go long in a variance swap is
very large. Furthermore, it is also shown that variance swap returns are negatively correlated
with equity and bond returns. Due to this negative correlation with equity returns and the
interest rate, it provides a hedge against some investment risks. However, if markets are
efficient, the advantages of volatility derivatives can be expected to result in higher prices
(Wallmeier & Hafner, 2006). Besides strategic (buy-and-hold) positions, some more dynamic
strategies will be investigated as well. These strategies, in which the investment depends on
the level of the VIX yield mixed results.
Because all these results are based on an asset-only analysis using historical data with a
relative short history, the conclusions are not very firm. Because of my internship at
-3-
Introduction
Algemeen Burgerlijk Pensioensfonds (ABP), the large Dutch pension fund for civil servants,
their viewpoint will also be used in the analysis. ABP asked me to investigate if and how a
new investment class can be used in the portfolio of the fund. Since a pension funds
performance depends heavily on the development of its pension liabilities, it would be
preferable to include these in the analysis as well. Therefore, an Asset Liability Management
(ALM) analysis will be performed. Although an ALM study is hard to perform for most
alternatives, due to short data history, there are still some interesting conclusions to draw from
such an analysis (Hoek, 2007). This study provides results based on scenarios run by the
ALM-model constructed by ABP. The advantage is that these outcomes give a better view of
the interaction between variance swap returns and the pension liabilities of ABP. For the
ALM study 3-month swaps are used. Again, going long seems to be very costly, but the ALM
model also shows that a long position does not provide much of the certainty that was hoped
for. It seems that a short position is very profitable, and is not nearly as risky as expected.
However, there are some periods in which the short position is extremely costly. Therefore,
again different strategies in which both short and long positions are taken are also being
investigated. These yield some interesting results, which will be analysed thoroughly.
The paper will proceed in the following way. In Chapter 2 and 3 the phenomenon and
definition of volatility is explained, after which volatility swaps will be introduced. Chapter 4
will then define the methodology of the research, while Chapter 5 will shortly explain which
data is being used. In Chapter 6 the first results from the asset-only study will be analysed.
Then in Chapter 7 the need for, and methodology of the ALM study will be explained, and its
results will be discussed in Chapter 8. In Chapter 9 some suggestions for further research will
be made. Finally, Chapter 10 will conclude.
-4-
2.
Volatility
VOLATILITY
Before we can assess whether or not volatility is a useful asset class, it is necessary first to
establish exactly what volatility is. In this paper volatility is defined as the standard deviation
of the logarithmic returns on an asset. Generally, this standard deviation is annualised in order
to enable an easier comparison between periods of different length. To calculate the returns of
the underlying asset, the daily closing prices are used. This means that any intra-day volatility
is not taken into account.
A high volatility is generally associated with stressful market conditions. This is a simple
conclusion because in times of uncertainty, investors moods swing up and down causing
large fluctuations in asset prices and returns. A second interesting aspect of volatility is that it
tends to be higher when markets go down, and smaller in rising markets. Again this makes
intuitive sense since a down-movement tends to be self-reinforcing which is generally not the
case in the event of an increase. A climbing market rather prompts investors to sell their assets
than to buy even more. A negative market development, however, makes investors nervous
and forces some investors to unwind their positions causing further decreases in the asset
price. In this paper the will lie on the volatility of the S&P 500. The S&P 500 contains 500 of
the largest companies (measured by market capitalization), of which most are American. It is
also one of the most actively used stock indices worldwide. Figure 1 shows the (annualised)
monthly volatility of the S&P 500 over its entire history. By far the highest volatility was
reached in October 1987, when the S&P 500 lost over 20% in one day, as a result of the
Black Monday stock market crash. Other periods of high volatility include the end of the
1990s with the Asian and Russian crises in 1997 and 1998 respectively; the early 2000s with
the bursting of the tech bubble and terrorist attacks on 9/11; and somewhat further back in
time, the 1970s with the oil crises.
-5-
Volatility
Monthly volatility of the S&P 500

100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
0%
Figure 1. Monthly volatility of S&P 500 returns.
For risk-averse investors who prefer stable (yet higher than the risk-free rate) returns, a high
volatility of returns is an undesired side-effect. Two days with both 1% return are preferred to
a one day decrease of 15% followed by an increase of 20%, even though both paths lead to
(practically) the same outcome. However, the second path might force the investor to close
some of his positions after day 1, because of the enormous drop experienced that day.
Naturally, if the more volatile path would lead to a higher outcome, some investors would
prefer it, but given the same outcome, always the lowest variability in returns is chosen.
However, this short-term volatility is less relevant for pension funds. Because the payments
and costs are all well-known in advance, a pension fund is a typical example of a long-term
investor, and there is less concern for short term returns. However, volatility derivatives can
still be useful as a portfolio diversifier. Since portfolio diversification is the easiest way to
enhance returns without taking on more risk (or reduce risk without lowering returns),
volatility is a very interesting asset class for pension funds. Until recently, investors had to use
options to gain an exposure to volatility.
2.1.
VOLATILITY INVESTMENT USING OPTIONS
Before volatility swaps existed, investors wishing to hedge or speculate on volatility had to
use options. The most straightforward method was buying a straddle and consequently hedge
this position to make it delta neutral. A straddle is a combination of a put and a call option
-6-
Volatility
with the same strike price and maturity. If the underlying asset is at the strike price on the
maturity date, the investor has a loss equal to the premiums paid for both swaps. However, as
soon as the underlying asset price has moved away from the strike price, no matter in which
direction, one of the options will be in-the-money. Consequently this combination of options
is profitable when the underlying asset price moves enough (or, is volatile enough) to
compensate for the two premiums. The payoff scheme of a straddle is shown in Figure 2. This
is therefore a direct and pure exposure to the volatility of the underlying asset at the cost of
two option premiums. However, as soon as the asset price has changed (before the maturity
date), the payoff is no longer solely dependent on the volatility but also on the direction in
which the underlying asset will move. This exposure to the asset price comes from the fact
that if the asset price moves back into the direction where it came from, any possible profit is
diminished. So if a drop in stock prices is compensated before maturity (or an increase
corrected) the straddle expires worthless. The direct exposure to the asset price is called delta
(or price) risk (Hull, 2005). If this risk is zero (as it is on initiation of the straddle), the
investment is said to be delta-neutral. To keep the position delta-neutral requires constant
rebalancing of the options, since after every change in the underlyings asset price the options
have to be sold, and new options with different strike prices have to be bought to regain the
clean or delta-neutral exposure to volatility. Naturally, this is time consuming and can also
lead to high costs. Apart from this, a complete hedge is impossible to achieve because of
market imperfections. For instance, continuous trading is not possible, liquidity could be
problematic for some options and the stock price occasionally moves with jumps leaving the
investors position unhedged. These problems are all the more present in case of single stock
option hedging. (Carr, Madan, Jouini, Cvitanic, & Musiela, 2001; Demeterfi, Derman, Kamal,
& Zou, 1999a; Hull, 2005; Wallmeier & Hafner, 2006). Other combinations of options, with
for instance one call and two puts or vice versa (a strip and strap respectively) have somewhat
differently shaped payoff schemes, but still face the same problems with delta-neutrality
(Hull, 2005).
-7-
Volatility
Figure 2. An option straddle. The dashed black line represents call option payoff, the continued line the puts
payoff. The blue line is the total payoff. K being the strike price, and ST the underlying (stock) price.
Now that volatility is defined and some basic methods of volatility investing have been
covered, it is necessary to determine what (volatility) swaps are, and how they are different
from other volatility derivatives.
-8-
Volatility swaps
3. VOLATILITY SWAPS
This part of the paper will explain what volatility and variance swaps exactly are. It will start
with an explanation of swaps in general before the focus will turn towards volatility and
variance swaps.
3.1.
BASIC SWAPS
In a swap contract two parties agree to trade a stream cash flows in the future, based on a
certain underlying asset such as interest or exchange rate or the volatility (Hull, 2005). Swaps
can therefore be seen as complicated versions of future contracts. Since the first swap contract
was initiated by the World Bank and IBM in August 1981, this market has grown to gigantic
proportions. In 1992 the total market value was only $630 billion, but in 2006 the notional
amount outstanding already exceeded $220 trillion (BIS, 2006; Neuberger, 1994). This
signifies a growth rate of over 33% per year. To engage in a swap, first, the notional amount
has to be determined (assuming the underlying asset is already known). The notional amount
is the amount on which all future payments are based. Since the notional amount is the same
for both parties, no exchange is needed on the initiation of the contract. In a simple swap, the
seller of the underlying asset pays the buyer a fixed rate on the notional amount per period. In
return the seller receives a floating rate based on exactly the same underlying asset.
Since interest rate swaps are the most common and well-known swaps they will be used as an
example; the selling party S pays the buying party B 3% interest per annum on a notional
amount of $1 million. This payment is made on a semi-annual basis, while the buyer pays the
prevailing market rate (LIBOR for instance). If the market rate turns out to be 4% over the
period, the buyer has to pay this 4%, while the seller pays his fixed 3%. Clearly, these
payments equal out partially, and only a net payment of 1% from the buyer to the seller is
necessary. Naturally, other notional amounts or interest rates can be agreed on when making
the contract (Hull, 2005). As can be observed there is not much capital needed to engage in a
swap. This is why it is such a popular tool for hedge funds and other daring investors. Using
the high leverage on swaps, they can make high return using relatively little initial investment.
-9-
Volatility swaps
The popularity and growth of the swap market can be explained by their versatility. First and
foremost, they can be used as a hedge against certain risks. A simple example again using the
interest rate swap explains this. Suppose Company A has a floating-rate loan on which it pays
LIBOR + 100 bp. Because of the LIBOR part in the loan, the business faces some interest rate
risk. The interest rate risk can be hedged away by entering a swap contract in which it
receives LIBOR while paying a fixed rate. Now Company A has transformed its floating-rate
loan into a loan with a fixed rate for which it now pays 1% + the agreed rate of the swap. If
the opposite party, for instance a bank, has written out a loan for which it receives LIBOR +
50 bp, then it too transforms its variable cash flow into a fixed income stream. Using a swap
for this transformation can be much cheaper than simply choosing a different loan with a
fixed payment. Since swaps are available on many different underlying assets, the hedging
possibilities hold for just as many assets.
With the example above, both parties reduce their interest rate risk. However, this is not
always the case as when one party reduces its risk; often another investor has to take on extra
risk. This is the second main use of swaps: speculation. Obviously, with one side of the
contract being variable, there is profit to be made if an investor is in the possession of extra
market information. Therefore, when a trader is expecting decreasing interest rates, he or she
can go short in an interest rate swap. If indeed the market rate decreases below the fixed rate
determined in the swap, this investor makes a profit. The risk of course, is that the interest rate
moves up instead, and the trader is faced with net payments/losses (Tang 2007). After interest
rate swaps, currency swaps are the most popular type of swap. Using a combination of these
two types of swaps, a Japanese company or investor can easily transform a floating-rate US
Dollar loan, into a fixed rate loan based on Yens. This way, any interest rate or currency risk
can be hedged away. In Table 1, the major swap types are shown, with their outstanding
amounts. As can be observed, the swap market is growing at a rapid pace. For instance, the
currency and interest rate swap market grew with 31% and 52% respectively between
December 2004 and December 2006. However, the fastest growing market, though still
relatively small, was that of equity-linked forwards and swaps. This market grew with an
amazing 133% in just two years. This table clearly shows the growing popularity of swaps,
and especially equity-linked derivatives such as variance swaps.
- 10 -
Volatility swaps
Table 1. From BIS, Semi-annual OTC derivatives statistics. Copyright 2007, Bank for International Settlements.
3.2.
VARIANCE AND VOLATILITY SWAPS
At the end of the 1990s and early 2000s, an innovative step was made in the swap market:
volatility and variance swaps on stock indices emerged. Although not entirely new, as
volatility swaps on currencies were already used for several years, these swaps covered the
volatility of stocks and stock indices. The swaps provided investors with an easy instrument to
speculate on or hedge future volatility of stock returns. In the early days, these volatility
swaps only existed for the most active indices, but over time volatility swaps also appeared
covering single stocks (Sulima, 2001).
3.2.1.
PAYOFF STRUCTURE
The structure of a volatility swap is similar to more commonly known swaps such as interest
rate swaps or currency swaps. The selling party, going short on volatility, receives a fixed rate
compensation for volatility. The buying party, being long on volatility, receives payments
based on the markets realised volatility. A variance swap is practically the same as a volatility
swap, only that the underlying asset is the variance, or volatility squared. Therefore the payoff
- 11 -
Volatility swaps
of a variance swap can be attained by simply squaring the strike and realised volatility. In this
paper the focus will lie on variance swaps, as they are more popular and common in the
market (see section 3.4). However, due to the direct link between variance and volatility,
variance swaps are also referred to as volatility derivatives. A visualisation of the payoff of a
variance swap is shown below in Exhibit 1. On the initiation of the contract, both parties
agree on the fixed rate, which is set in such a way that no payment is needed at initiation. This
requires using the forecasted volatility, so that the expected net-present-value of future
payments equals zero.
The cash flows of a variance swap at maturity
[Strike/implied volatility]2
Buyer (long)
Seller (short)
[Realized volatility]2
Exhibit 1. Cash flows of a variance swap.
The
payoff
of
variance
swap
is therefore directly linked to the realised
2
2
variance: R2 K vol
* N , where R2 is the realised variance over the life of the swap, K vol
the
strike or implied variance, and N the notional amount. Please note the difference between
2
, the strike of a variance swap, and (K vol ) , the square of the strike of a volatility swap.
K vol
2
Even though variance is the square of volatility, these two strikes need not be the same. As the
strike is simply the price of the swap, they can behave differently in different market
circumstances. As can be seen in Exhibit 1, the owner of the swap receives N dollars for every
percentage point the realised variance exceeded the strike variance. For the seller of the swap,
the payoff would be exactly reversed, yielding a profit when the realised variance is below the
strike variance.
As there is no initial investment required to engage in a swap, the yield calculation is also
somewhat more difficult than for a more common asset such as stocks. The yield of a (long
position in a) variance swap can be calculated can be calculated with the following formula:
- 12 -
return =
2
R2 K vol
2 K vol
Volatility swaps
(Formula 1)
2
where again R2 is the realised variance, K vol
the strike/implied volatility. In the contract all
details are described, such as the date of payment and value of the underlying notional. Also,
the method of calculating the realized variance has to be specified. This includes three
important points: firstly, the observation frequency of the underlying stock or stock index has
to be determined. Generally, a daily frequency is used on a liquid stock or index such as the
S&P 500. Secondly, the annualisation factor has to be determined. Typically 250 trading days
are used as a basis (Demeterfi, Derman, Kamal, & Zou, 1999a). All these factors lead to
custom designed contracts, which disable them from being traded publicly. Variance swaps
can therefore only be traded in an over-the-counter (OTC) market. The disadvantage of an
OTC market is that it reduces the liquidity and positions are harder to sell. However, the
variance swap market is growing at such pace, that the problem of liquidity might be
negligible in a few years time.
With the emergence of volatility and variance swaps, the variability itself of, for instance, a
stock index could now be used as an asset. The reason why volatility can be an interesting
asset is two-fold. First and foremost, as explained above, most investors are naturally short on
volatility and can therefore use volatility swaps to hedge their exposure. However, volatility
also has several unique traits, which make it an appealing asset not only as a hedge, but also
to actively trade in.
Volatility increases in times of uncertainty and high risks, providing a hedge
for risk-averse investors, or another speculation possibility for others.
Volatility is mean-reverting; low volatilities are expected to rise and high
volatilities will probably decrease (Demeterfi, Derman, Kamal, & Zou, 1999a).
Generally volatility is negatively correlated with the index or stock level, and
will remain high for some time even in the aftermath of a collapse. Investors will be
on their guard after a sharp correction, and their increased anxiety will probably lead
to high levels of volatility. This characteristic makes volatility an interesting asset
for diversification purposes, as it moves in the opposite direction of equity markets
(Ramchand & Susmel, 1998).
- 13 -
3.3.
Volatility swaps
VOLATILITY VS. VARIANCE SWAPS
Up to this point, the terms volatility and variance swaps have been used interchangeably in
this paper, mainly since they both intend to do the same thing: hedge against instability of
asset prices. However, there are some important differences which need to be addressed. All
these differences relate to the difference between variance and volatility. As explained above,
volatility is the standard deviation of returns, and variance is volatility squared. The advantage
of a variance swap (or disadvantage, from the sellers point of view) is the convexity caused
by the squaring of volatility. This convexity causes the payoff of variance swaps to be nonsymmetric, while for volatility swaps the payoff is linear and symmetric. A long position in a
variance swap gives relatively high potential profits, while the losses are practically capped.
The payoff of a long variance swap therefore rises at a higher rate than the volatility has
increased (Sulima, 2001).
Volatility and variance swap returns

8,00%
6,00%
Return swap
4,00%
2,00%
0,00%
-2,00%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
-4,00%
Volatility swap
-6,00%
Variance swap
-8,00%
-10,00%
Realised volatility
Figure 3. Volatility and variance swap returns. Both swaps have a strike volatility of 50%.
In Figure 3 the payoff for a long position in a volatility and a variance swap is illustrated
2
= ( K vol ) 2 . However, as the can be observed this provides the variance swap with
where K vol
an advantage over the volatility swap. The payoff of the variance swaps is at least as high as
the payoff of the volatility swap. However, in real life this situation would probably not be
observed. Market efficiency would price a variance swap higher and the strike of a variance
2
swap in general tends to be higher than for a volatility swap K vol
> ( K vol ) 2 , placing the
- 14 -
Volatility swaps
continued line to the right, and (at least partially) below the volatility swap returns (Allen,
2004; Demeterfi, Derman, Kamal, & Zou, 1999a).
3.4.
PRACTICAL APPLICATIONS OF VARIANCE SWAPS
Due to the particular characteristics of volatility, variance swaps can be used for different
strategies. As explained before, all swaps can be used as a hedge. In the case of variance
swaps, this is very convenient since many investors are inherently short in volatility. Clearly,
investors who follow a benchmark will see their tracking error increase in times of higher
market volatility. Even if the investor is able to follow the benchmark he will incur higher
transaction costs, when volatility is high simply because of the necessity of more frequent
rebalancing of his portfolio. Another example of volatility risk relates to hedge funds which
speculate on the spread between two merging companies stocks will decrease. If the market
volatility increases, this might jeopardise the merger and the spread will increase instead of
decrease. In fact, most equity investors are short on volatility because of the negative
correlation between volatility and index levels (Ramchand & Susmel, 1998). As Ramchand
and Susmel (1998) show, covariances and correlations are higher during times of increased
volatility. In such market situations the use of (global) stock diversification is reduced, and
the investor faces extra volatility risks. Another contributing factor is that global
diversification nowadays seems to be less effective than it once was also in low volatility
environments. As Goetzman, Li and Rouwenhorst (2005) show, global correlations have
increased over the past decades, again leaving less room for diversification benefits.
Therefore, volatility derivatives have become increasingly popular as hedging tools.
A second strategy which can be exploited using variance swaps is to trade the spread between
implied and realised volatility. Since the implied volatility is used as the fixed part in the
swap, it is set at initiation. However, over the lifespan of the swap, the realised volatility is
likely to be different from the implied volatility as set in the swap. As explained before, a
variance swap provides a hedge against volatility or variance risk. This risk is priced for in the
price of the swap which is the strike volatility. On average this would lead to an implied
variance that is higher than the subsequent realised variance. Trading on this difference can
prove to be a profitable strategy (Demeterfi, Derman, Kamal, & Zou, 1999a).
- 15 -
Volatility swaps
The third strategy that can be used is speculative trading on the direction of volatility.
Naturally, in the global equity market there are always different opinions to be found on the
expectation of the level of volatility. If an investor expects an increase in volatility, for
instance because of political unrest, he can take a long position in a swap and profit from this
increase. Naturally this is only profitable when the expectations are not commonly shared, and
the strike volatility has not incorporated this expectation (Demeterfi, Derman, Kamal, & Zou,
1999b). This shows there are many different reasons why an investor would want to invest in
volatility derivatives.
As the main possibilities of volatility investing using variance swaps have been covered, the
next step is how to calculate the returns necessary to judge these instruments and specific
strategies.
- 16 -
4.
Methodology
METHODOLOGY
To find an answer to the added value of variance swaps in a pension fund portfolio, it is
necessary to first calculate the returns. In this section the methodology is described how these
returns are calculated. Some aspects of the swap contract will be explained more thoroughly.
As explained before, the payoff of a (long) variance swap is simply the realised variance
2
minus the strike variance, multiplied with the notional amount; R2 K vol
* N , where N is
the notional amount. The notional amount is irrelevant for (percentage) returns, but will be
explained nonetheless.
4.1.
VIX
The most important aspect of a variance swap is the underlying stock (index). In this paper the
S&P 500 will be used. In order to find the strike volatility of the variance swaps, the Volatility
Index is used. The Volatility Index, or VIX, is in an index launched by the Chicago Board
Options Exchange (CBOE) in 1993. It can be regarded as a measure for (expected) stock
market volatility. The VIX is by many regarded as the benchmark in stock volatilities
(Whaley, 2000). The basic idea is that the VIX shows the forecasted stock market volatility
over the next 30 calendar days. This expectation is constantly (re)calculated with the use of
option prices on the S&P 500 index. In September 2003 the calculation method was updated,
and the switch was made from the S&P 100, to the S&P 500. Since the S&P 500 is the index
which has the most active stock index derivatives, this was a logical change. The updated
formula also takes a wider range of option strike prices into account. Previously, only at-themoney options were considered. As was shown in the article the new VIX level is quite
comparable to the old one (VIX CBOE Volatility Index, 2003).
In times of financial unrest, accompanied often by sharp market declines, the option prices,
and therefore the VIX generally tend to rise. This is the reason why the VIX is also called the
fear gauge. Once the unrest decreases again, the option prices move downward again, and
the VIX also decreases (VIX CBOE Volatility Index, 2003; Whaley, 2000). The highest level
the VIX has reached was 45.74, which was on October 8th, 1998, in the aftermath of the
Russian crisis. The lowest level ever attained was 9.31 reached on December 22nd, 1993. The
average level of the VIX between 1990 and May 2007 was 18.9.
- 17 -
Methodology
The method of the calculation of the VIX is rather complicated. The expected volatility is
obtained using the average of the weighted prices of out-of-the-money put and call options. In
this way, the entire volatility skew is considered. The volatility skew, or sometimes called
smile, shows that the implied volatility is lowest for at-the-money options. This is not
consistent with the Black-Scholes model which states that the implied volatility should be
equal for all strike prices. Also, the implied volatilities show a negative correlation with strike
prices. This strange trait is a relatively new phenomenon. Before the stock market crash in
October 1987 no volatility smile existed but in the years afterwards it was clearly visible. The
October 1987 crash probably made investors more aware and averse of the possibility of such
a crash, increasing the implied, or expected volatility (Derman & Kani, 1994). The exact
calculation of the VIX is shown in Exhibit 2.
Calculation of the Volatility Index
K
2
1F
= 2i e RT Q( K i )
1
T i Ki
T K0
Where
VIX/100 (or VIX = * 100)
The time to expiration
Forward index level which is derived from the index option prices
Ki
The strike price of the ith out-of-the-money option, being a call when Ki>F and a
put if Ki<F
Ki
The difference between strike prices; half the distance between the strike price
on either side of Ki
K i +1 K i 1
2
The risk free rate to expiration of the option
K i =
Q(Ki) The middle of the bid-ask spread for option Ki

K0
The first strike below the forward index level F
(VIX CBOE Volatility Index, 2003)

Exhibit 2. Calculation of the Volatility Index.
- 18 -
4.2.
Methodology
NOTIONAL AMOUNT
The notional amount is in a sense the size of any swap. It is the sum by which the difference
between the fixed and floating leg of the swap needs to be multiplied to find the total payoff.
The notional amount of a variance swap can be considered as the sensitivity towards
volatility. The notional amount for variance swaps is generally $100,000 for variance swaps
based on an index. For swaps on single stock the notional amount is usually $50,000. As the
notional amount is only a nominal term, it is not needed to find the returns on variance swaps.
4.3.
REALISED VARIANCE
The realised variance is calculated in the following way:

2
SPX t 250
*
R ealised variance = ln
T
t =1 SPX t 1
T
(Formula 2)
where SPXt is the closing level of the S&P500 on day t. As an annualisation factor 250/T is
used, with T being the number of trading days (with approximately 250 trading days in one
year). In order to calculate the monthly returns needed for the ALM analysis, the realised
variance is calculated on a monthly basis. This is not entirely correct, since technically
speaking the VIX calculates the implied volatility for the next 30-day period, which is not
always the same as a month. However, the difference between the 30-day and monthly
variance is negligible. Also note that a mean of zero returns is assumed. In statistical
textbooks, when calculating the standard deviation or variance, the mean return needs to be
subtracted first. As this is not done in the over-the-counter market, the outcome will be
slightly different from a textbook calculation (Hosker & Dholakia, 2004).
4.4.
YIELD
To calculate the yield on variance swaps Formula 1, return =
2
R2 K vol
2 K vol
is used. The input for
this formula was described in this section. First of all, the realised variance is calculated using
Formula 2; then the VIX2 is subtracted as the fixed leg of the swap. The total is then divided
by 2*VIX. With the yield calculated it is possible to analyse these instruments and see if, and
how, they can be used in a pension funds portfolio.
- 19 -
5.
Results
DATA
There is not a great amount of data necessary to make the analyses in this paper. Only strike
(or implied) and realised volatilities were necessary. Unfortunately, it is not possible to use
real-life strike volatilities to make the calculations. Because of the short time span that
variance swaps exist, they cannot be used to draw reliable conclusions. However, as explained
before, the VIX can be seen as a good indicator of implied (or expected) volatility and is
therefore used as a proxy for the strike volatility. The data of the VIX was retrieved from
DataStream. The realised volatility is of course easily calculated using the closing levels of
the S&P 500. Both data sets are available on DataStream. The entire data set therefore runs
from January 1990 up to May 2007. All in all, this results in 207 monthly observations, which
should be enough to draw conclusions from.
6.
RESULTS
In this section of the paper the main characteristics of the variance swap returns will be
discussed. The returns have been calculated using Formula 1. It will start with looking at
some straightforward indicators showing the return, standard deviation and correlations with
other assets. Firstly, two strategic investments are presented. Strategic in this context means
that the same investment, either long or short, is made every month, disregarding any market
circumstances. The first strategic investment a long position every month is made to
reduce risks. As explained above, it is expected that the return on variance swaps is negatively
correlated with stock returns and therefore this position should hedge volatility as well as
stock market returns. It can be expected that this hedge comes at a premium and that this
position has a negative yield. Here it is examined how much this hedge costs and what
benefits it can provide. The other strategic investment, and all others that come after, are
aimed at providing the investor with a positive payoff without taking on extra risk. After the
basic traits of strategic investments have been covered, an attempt is made to enhance the
risk-returns profile through some dynamic trading. Instead of simply going long or short
every month, the decision to buy or sell the swap is made dependent on the level of the VIX.
- 20 -
Results
These tactic strategies seem to improve the returns made compared with strategic investments.
In the entire paper, all transaction costs are assumed to zero.
6.1.
BASIC INDICATORS LONG AND SHORT STRATEGY
After calculating all the returns over the past 17 years, it is found that going long in a variance
swap is in general not a profitable investment. Fortunately, this was also not expected. As said
above, due to its negative correlation with stock returns, a variance swap can be seen as a
hedging tool for stock market crashes. In this perspective, a negative payoff is expected and
can be considered a risk or insurance premium. This premium can also be seen in Figure 4,
which shows that in general, the Volatility Index (VIX) lies somewhat above the realized
volatility. Naturally, there are some examples where the realized variance jumps up to levels
higher than the VIX. These shocks of realized variance occur when there are large
fluctuations of stock price returns. Some examples are clearly visible in the graph; 1997, the
Asian Crisis when the S&P 500 plummeted with over 7% on October 27th; not even a year
later, the Russian Crisis emerged, leading to a drop of again over 7% on August 31st; the
bursting of the dot-com bubble in March/April 2000 also led to increased volatilities, as did
the dramatic events on 9/11, even though in the case of the terrorist attacks the first shock
was diminished because trading was suspended for four days; finally, and most dramatically,
July 2002 stands out as the largest (positive) difference between implied and realized
volatility. Although there was not one clear event that caused it, July 2002 was one of the
most volatile months in recent history. This volatility was caused by the ongoing bear market,
and bursting of the dot-com bubble. Also, a decrease of the Dollar against the Euro and some
large-scale accounting scandals such as Enron and WorldCom added tension to the already
nervous stock markets. In the first three weeks of July (up until the 23rd), the S&P 500
decreased from 989 to 797, resulting in a loss of well over 19%! However, in the six trading
days left in July, the S&P 500 jumped up with over 14%, regaining part of the ground lost
earlier that month, ending on 911 points. This example once again shows that the payoff of a
variance swap is path-dependent. The overall loss in that particular month, yet high, was only
8%, but the route taken to reach that 8%, had lead to a volatility of well over 40%. It is
evident that in this particular example an option straddle would have underperformed
compared with a variance swap, as the straddles payoff only depends on the final level of the
index, and is not path-dependent.
- 21 -
Results
The examples show the clear negative relation between volatility and stock returns. All
examples of realized exceeding implied volatility were caused by substantial falls (either with
or without a rebound) of the index. This again underlines the insurance aspect of being long
in a volatility/variance swap. As with a regular insurance, you pay money most of the time,
but when you need it most, your insurance pays you out. Unfortunately, another feature of
insurances is that on average the insurance buyer loses money. In fact, this is a necessary
condition for other parties to supply the insurance. The difference can simply be seen as a
premium paid to obtain the insurance. This is also an explanation for the interesting pattern
shown in Figure 4. Almost every time after the monthly realized volatility was higher than the
VIX, the level of the VIX jumped up, leading to a sharp decrease in the difference, often even
lower than the average difference. For instance in November 1997, as a reaction to the Asian
crisis the VIX increased to 35, while the realized volatility decreased after being almost 10
percentage points higher in the month before.
Implied and realised volatility of S&P 500
50
40
30
20
10
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
-10
1990
-20
-30
VIX
Realized
Difference
Figure 4. Implied and realised volatility of S&P 500.
6.1.1.
STRATEGIC INVESTMENT (STRATEGY I & II)
As said above, a long position in a variance swap can be seen as an insurance against a stock
market crash. One would expect that this insurance is not free, but some premium has to be
paid. This premium show itself in the difference between the implied and realized volatility,
- 22 -
Results
or simply the average return of the variance swap. As expected, this return is negative, and on
average -3.7 percent per month. The standard deviation of returns is approximately 4%. This
is a rather substantial premium, leading to an average loss of over 40% per annum! However,
as explained before, in a variance swap the downside risk is somewhat capped, yet the upside
potential is (theoretically) unlimited. Therefore, the selling party of the swap bears a lot of
risk, and it is natural that it wants to be compensated for this. The returns for a one-month
variance swap are shown in Figure 5.
Variance swap returns
25,00%
20,00%
15,00%
10,00%
5,00%
0,00%
-5,00%
-10,00%
-15,00%
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
-20,00%
Figure 5. Long variance swap return (1 month).
As can be observed in the graph, a long position in a variance swap is not a very profitable
investment. Most months lead to a negative return, and only a few months provide the
investor with a positive yield. In fact, we only observe positive payments in 23 of the total
207 months. Using this strategy would have provided the investor with a positive payment
once every 9 months. The graph further suggests a rather skewed return distribution, with a
few positive outliers and many observations around -5%. Table 2 shows some key-statistics
for the returns of 1-month variance swaps.
- 23 -
Results
Variance swap return

Mean
-0.0373
Standard Deviation
0.0406
Sample Variance
0.0016
Kurtosis
8.9483
Skewness
1.9579
Minimum
-0.1339
Maximum
0.2125
Count
207
Table 2. Variance swap returns, summary statistics.
Table 2 shows that most of our ex ante impressions on the basis of the first graphical analysis
of the data are correct. The kurtosis of 8.94 shows that most of the variation in the return
distribution can be explained by extreme outliers and relatively fat tails. These are generally
the positive months, although there are some extreme negative returns too. Secondly, the
positive skewness of 1.95 suggests that indeed the larger part of the distribution is found on
the left hand, and the right-hand tail (with the positive returns) is largest. This confirms the
pattern observed in graph 1, which showed that generally we lose money, but every now and
then a rather high return is received. Even though this strategy obviously is very costly, is
should not be ruled out immediately. Expectedly it yields a negative payoff, but it also
reduces investment risks. A simple measure for the calculation of investment risks is the
standard deviation and skewness of returns. Here, Portfolio A, with 100% invested in the S&P
500, is compared with Portfolio B, which has 90% invested in the S&P 500 and the other 10%
in (long) variance swaps. Even though the average return for Portfolio A is much higher,
0.8% versus 0.4%, it standard deviation is also much higher, 4.0% compared with 3.4% for
Portfolio B. Portfolio A also has a strong negative skewness of 0.48, while the skewness in
Portfolio B is only 0.39, signifying that the probability of negative outliers is reduced by the
variance swap holdings. This suggests that the long position indeed reduces investment risks,
and can be interesting despite its high costs. Naturally, there are other ways to hedge and
reduce investment risks. Unfortunately, there is no possibility to make a fair comparison
between these methods here in this thesis.
6.1.2.
CORRELATIONS
Even though the average returns are not really promising on itself, volatility, or variance
rather still can prove to be an interesting asset. Beforehand, we already expected a negative
payoff, simply because of the insurance-like profile of the variance swap. The question then
remains how much insurance is received for the premium paid. This can be measured by the
- 24 -
Results
diversification benefits a long position provides. To find an answer to this question, the
correlations of variance swaps with other assets need to be examined. The most relevant
correlations, considering the current portfolio of ABP, are shown in Table 3 below.
Variance swap correlations
S&P 500
-0.447
MSCI world
-0.402
10yr bond yield
-0.095
Dutch inflation
0.000
S&P Commodity index -0.035
GPR 250 Europe
-0.162
Table 3. Variance swap return correlations.
As can be seen in the table, variance swap returns show a strong negative correlation of -0.44
with stock returns. This means that if the S&P 500 decreases with 1%, the return on variance
swaps increases with 0.44%. As explained before, this negative correlation is due to the
simple fact that in general decreasing stock markets are more volatile than increasing stock
markets. Also, daily decreases (in absolute terms) are on average larger than increases. That
this relationship holds so strongly for the S&P 500 is quite logical, since the realized variance
is calculated using this particular index. However, the relationship seems to be almost as
strong for stocks in other markets, as the correlation of -0.40 with the MSCI World index
shows. A negative correlation is a good risk diversifying characteristic. If the investor loses
money on his stock holdings, at least money is received from his variance swaps. Since
equities make up one of the largest parts of assets for most investors, a negative correlation
between equity return and variance swap return is very useful in portfolio diversification.
Apart from the negative correlation with stocks, the correlation with interest rates is of high
importance for an investor. Since bonds still make up a large part of the average investors
portfolio, the correlation between bond yields and variance swap returns is also of high
importance. For pension funds this correlation is even more important as the liabilities of
pension funds are highly influenced by interest rate movements. Since the liabilities are
discounted using the prevalent interest rate, an increase in the interest rate is in fact profitable,
as the Net Present Value of future liabilities decrease, and the funding ratio increases. So
again, the negative correlation between variance swaps and bond yield is beneficial, because
when both the returns on bonds decrease and the liabilities increase, variance swap returns
- 25 -
Results
help compensating the negative shocks by yielding a positive return. Unfortunately, with only
-0.09 this negative correlation is not as strong as hope for.
A second major influence on the liabilities of pension funds apart from the interest rate is the
inflation rate. Practically all pension funds have the intention, if not the obligation, to
compensate their pensions for inflation. Therefore changes in inflation can have serious
consequences for their liabilities and the funding ratio. Since wage inflation data, being the
ideal indexation target, is not readily available, price inflation is used instead. Even though
this is not entirely correct, as wage inflation generally lies above price inflation, price
inflation can still be considered a good proxy. What is found is that the correlation between
inflation and variance swap returns is practically zero. A positive correlation would of course
be optimal, but zero correlation is not a bad result..
Other correlations shown in Table 3 are mainly of interest to determine how variance swaps
can help as risk diversifiers. As can be seen in the table, also with other assets, such as
commodities and real estate, variance swap returns have beneficial negative correlations.
Naturally, there is some overlap since certain stock of the real estate and commodity market
might also be used calculating the S&P 500 or the MSCI World, which might explain part of
the negative correlation. However, correlations of -0.03 and -0.16 with the commodity and
real estate indices respectively, are good results.
So far all results have been presented as if the investor takes a long position in the variance
swap. However, a short position is of course also possible. Then, instead of hedging the
volatility risk, the investor takes on extra risk and is rewarded for this. The result for such a
strategy is simply the opposite of the long position described above. The payoff is thus +3.7%
per month. The extra risk naturally comes from the correlations which also change sign. The
negative correlation with stock returns turns positive, leading to even larger accumulated
losses in decreasing markets. Going short can therefore be very profitable but should only be
considered by long-term investors who are (by nature) not too risk-averse, a description that
perfectly suits pension funds. With such an extreme premium it seems that the only reason to
go long in variance swaps is to receive protection from market crashes and large shocks in the
short term. However, it seems that over the time period examined here, this protection was
highly paid for.
- 26 -
6.2.
Results
DYNAMIC TRADING
Besides choosing in advance to go long or short under all prevalent market circumstances, it
is also possible to make this decision based on certain market criteria (timing). If it is possible
to time your investment in such a way that you are on the (net) receiving end of the swap each
month, it can be very profitable. This means that you are long in times of high but unexpected
market stress, but short otherwise. Naturally such a perfect strategy is practically impossible,
yet some market timing can prove to be profitable if the skills of the trader are good
enough. In order to investigate whether such timing can indeed be profitable, several kinds of
strategies are constructed, and their results will be evaluated in the following section. In order
to assess the value of these strategies, their average return and risk factors will be analysed.
As was shown in Figure 5, a long position is rarely a profitable investment. However, if timed
well, a long position can yield very good results. Since most strategies will go long at some
point in time, the returns per type of position (long or short) will also be analysed. Another
reason to go long, is for the hedging qualities. Therefore, also the results of the strategies for
the 5 most volatile months in the sample period will be shown. These months are October
1997, August 1998, April 2000, September 2001, and July 2002. Since variance swaps can
also be used as a hedge against a fall in equity prices, the same analysis is done for the worst 5
monthly performances of the S&P 500, excluding the months mentioned above in order to
obtain a better view of the results. These months are August 1990 (-9.0%), November 2000 (7.9%), February 2001 (-9.1%), June 2002 (-7.1%) and September 2000 (-10.9%). A positive
payoff of the swap in these months suggests that the strategy provides us with a hedge at the
moment it is most needed, while a negative result would suggest we take on (too much) risk.
For this part of the analysis the same data set is used as with the strategic investments. The
data runs from 1990 until 2007. The table in Appendix 12.B. holds the key statistics for all
strategies described here. Since these strategies are evaluated based on their historical
performance, one needs to be careful when drawing general conclusions. First of all, data
mining is easy by setting the parameters in such a way that the outcome suits the authors
ideas. This problem is hopefully avoided by setting the boundaries of the strategies before
doing the analysis. Secondly, a good historical performance is not necessarily a good
predictor for the future. We might have been just lucky with our sample period. This
problem will be dealt with later, by performing an ALM analysis, which uses a stochastic
model to generate possible scenarios and results. The results from the ALM study will be
explained in the next chapter.
- 27 -
6.2.1.
Results
STRATEGY III
The first strategy considered makes use of the mean-reverting nature of volatility. Therefore,
in this strategy a long position is taken whenever the VIX is below 15, which is generally
considered a rather low level and an increase of volatility can be expected. A long position is
also taken in times of high uncertainty. This is measured using again the level of the VIX; if it
is above 30, the market is considered stressed a long position is taken (Whaley, 2000). In the
average market, it was shown the variance swap was most profitable for the seller.
Therefore, when the VIX is anywhere between 15 and 30, a short position in the swap is
taken. To summarise Strategy III:
15 < VIX < 30
Short
VIX < 15 or VIX > 30
Long
This strategy results in an average return of 0.93% per month (or almost 12% per year). In
total 83 times a long position is taken, while on 124 occasions we end up holding a short
position. The average return in the months that we took a long position is -3.47%, while the
average return in the months we were short was 3.89%. This result seems to suggest that this
strategy has its merits. Since the positive returns from writing the swap have increased, and
the losses from going long have decreased, some of the assumptions might have held. It was
possible to pick out the months in which the long position is not as costly as it is on average.
Also, the results suggest that it is possible to time our short position to make it more
profitable. However, this difference is not as large as hoped for, and the main contributor to
the final average return is simply the number of months we go short. However, by going short
in most months, we implicitly take on extra risk. This risk is reflected in a higher standard
deviation than with the strategic investments, namely 5.4%. This also shows when we look at
the performance in the worst 10 months. In the months with the highest volatility this
strategy yielded -13.09% on average. And also in the worst months of the S&P 500, this
strategy had a negative average return, -0.26%. Of the 10 different months considered, in fact
only twice we were on the receiving end of the swap. All in all, this strategy yields a nice
return during this sample period, but this comes at the price of a higher risk.
- 28 -
6.2.2.
Results
STRATEGY IV
The second dynamic strategy considered is in some way the opposite of Strategy III. Even
though the disappointing results of Strategy III described above, may have pushed in this
direction, there are some clear theoretical arguments why this would be a good strategy. As
the VIX is generally somewhere between 20 and 30, this strategy expected to be a safer
strategy with relatively more long positions and fewer short positions. A long position is
taken whenever the VIX is between 20 and 30, while in all other cases a short position is
taken. The reasoning behind this strategy is that when the VIX is above 30, the market is
highly stressed, and the premium for taking on extra volatility risk (going short) is high. With
the VIX this high, it is also unlikely that the realized volatility exceeds the VIX. In this light,
we can expect a short position to yield a positive result. We also take on a short position when
the VIX < 20. This paradoxical position is taken because the data suggest that if the VIX is in
these low regions, markets are really calm. The VIX seems to move hardly below 15, even
though there are months when realized volatility is below 10. A long position is taken
between 20 and 30; these are normal levels for the VIX, and the chance of an unexpected
jump (and therefore exceeding implied volatility) in volatility is probably highest within this
channel. Summarising Strategy IV:
20 < VIX < 30
VIX < 20 or VIX > 30
Long
Short
This strategy does very well in the sample period yielding a positive return of 1.17% per
month! Due to the boundaries chosen, we go short on 136 occasions, while going long in only
71 months. The average return of the long positions is however still negative, -3.7% while the
short positions yield +3.7%. Since this is in line with the results from the static strategies, it
seems the percentage of going long or short again has the highest influence on the outcome.
However, there is still an advantage of this strategy compared to the one described above. In
the months with the highest realised volatility, this strategy yielded a nice 13.09% return. On
the other hand, in the worst S&P months, this strategy performs not as good, with an average
return of 0.40%. All in all, in seven out of ten months, this strategy led to a positive result.
Unfortunately, the standard deviation of the returns is still high at 5.4%. It seems this strategy
performed very well in the period described here, but is not without risks.
- 29 -
6.2.3.
Results
STRATEGY V
The third and last strategy investigated here, is again an only short strategy. However, this
strategy only goes short when the market is stressed; indicated by the VIX exceeding 25. A
long position is not taken, as previous results show that it is too costly to be useful. As
explained before, when the VIX is high, then the premium for volatility risk is higher, and a
short position is likely to give a good result. To increase the number of trades so that
conclusions are more reliable, the boundary has been lowered from 30 to 25 compared with
Strategy IV. Since no position is taken when the VIX is below 25, this is just an adapted
version of the strategic short strategy. To summarise Strategy V:
VIX < 25 No position
VIX > 25 Short
This strategy does not require constant positions, and there is only an active position in 34 of
the 207 months. However, in these months the strategy yields on average 5.54%. Of course
this number should be treated with care due to the infrequent nature of trades, but this is
obviously a very high return. By not trading in part of the months, we are able to get a better
performance than with a static short position. Furthermore, the expectation that it is unlikely
that with the VIX already relatively high, there will be a jump in volatility seems to be
confirmed. Only on two occasions in the worst 10 months did this strategy hold a position.
Once, in September 2002 it yielded a positive return of 1.94%, but on the other occasion, July
2002, the position cost us dearly, -21.25%. The standard deviation of returns for this strategy
is the highest seen so far, 6.1%. All in all, this would be a risky, but highly rewarding
strategy.
In this chapter it was shown that a strategic, risk-averse, long-only position is very costly, but
does indeed reduce investment risks. On the other hand, a short position turned out to be very
profitable. Furthermore, some dynamic trading strategies were analysed. It can be concluded
from these results that through some basic market timing, good returns can be obtained.
Returns, which are in most cases superior to those coming from a strategic long or short
position. However, the risk of making the wrong decision is quite large, as the market will not
be easily predicted. Naturally, these results need to be interpreted with caution, as they are
based on just one data set, covering 17 years of data.
- 30 -
Asset-Liability Management
ASSET-LIABILITY MANAGEMENT
7.
As explained before, in this thesis it is investigated whether variance swaps add value to the
existing portfolio of ABP. In this part of the paper, two different methods to analyse the
performance of an asset within a portfolio will be looked at. Firstly, the relatively
straightforward method of portfolio optimization will be explained. After this is done, it will
be explained why Asset-Liability Management (ALM) is more suitable as an analysis tool for
pension funds.
7.1.
MARKOWITZ PORTFOLIO OPTIMIZATION
The most straightforward way to determine whether or not an asset provides added value is to
use portfolio optimisation. Simple portfolio optimisation is based on the property that two
assets with non-perfect correlations together have lower variability in returns than
individually. This is in sharp contrast with the return which is simply a weighted average of
all components of the portfolio. Mathematically speaking, the variance of the portfolio is:
N
i =1
i =1 i >1
Variance = i2V ( X i ) + 2 i j ij
Where i is the weight of asset i in the portfolio, and ij the covariance of asset i and j. The
strength of portfolio management and diversification lies in the property that ij<1, which is
generally the case. In the unlikely event those assets behave identically, so that ij=1, there is
no advantage to be made by diversification (Markowitz, 1958).
From the property explained before, a global minimum variance portfolio (GMV) can be
found. This is the combination of assets which has the lowest variance attainable. Generally
speaking, the GMV portfolio also has rather low returns. Therefore an investor may choose a
portfolio different from the GMV portfolio. This is of course possible, as long as the portfolio
chosen is efficient. The mean-variance analyses states that the efficient set of portfolios
consists of those portfolios whose returns are not possible in combination with a lower
variance, or conversely, the variances for which no higher return can be made (Markowitz,
1976).
- 31 -
The mean-variance analysis can quite simply show the added value of an asset by assigning a
weight to the new asset in the portfolio targeted by the investor. However, the major
disadvantage of this method is the fact that it is viewed from an asset-only perspective. This
means there is no consideration of the (cor)relations between the assets and the liabilities.
This is of course of no concern for trust funds as they do not have liabilities. However,
pension funds by nature have enormous outstanding liabilities in the form of future pensions
they are obliged to pay out. Since pension liabilities are almost as volatile as assets, pension
funds will hold certain assets to match their liabilities. Therefore, the ideal asset from a
pension funds point of view is also highly correlated with their liabilities. Since these
characteristics are ignored in the Markowitz optimisation, it is decided not to use the portfolio
optimization method.
7.2.
ASSET-LIABILITY MANAGEMENT
Instead of the basic portfolio optimization, a more advanced method of analysing asset
classes, the so-called Asset-Liability Management (ALM) study is being used here. The
advantage of this analysis compared with portfolio optimization is that it explicitly takes the
liabilities into account. This can lead to very different outcomes of the optimal investment
mix. Some assets for example might have a low return with a relatively high variance, making
them hardly attractive in an asset-only context. However, if the same asset has a very high
correlation with the interest rate, one of the main drivers of pension liabilities, it might
perform very well in an ALM setting. So where in Markowitz portfolio optimisation the
variance of returns is the prime target, the ALM model focuses on the variance of the surplus
of the assets over the liabilities.
7.2.1.
THE BASIC IDEA BEHIND ALM
As explained above, and can be concluded from the name, an Asset-Liability Management
analysis looks at both the assets, and the liabilities of a (pension) fund. This adds a new
dimension to the asset, and gives rise to new insights into the added value of inclusion of the
asset into the portfolio. The ALM analysis makes use of scenarios to determine (long-run)
correlations between assets classes and between assets classes and liabilities. These
- 32 -
correlations are likely to be different over different horizons. Since pension funds are by
nature long-term investors, their interest does not lie in short-term correlations. Instead, they
are more concerned about long-term (10 to 25 years) correlations, which might be very
different from short term correlations. As Campbell and Viceira (2005) show, the annualised
standard deviation of real equity returns decreases from almost 17 percent in one year, to
below 8 percent with a horizon of 25 years. This enormous decrease in risk is mainly caused
by the mean-reverting nature of stock returns. However, other asset classes such as bonds held
to maturity show mean averting real returns (because inflation is not covered), resulting in
higher standard deviations with increasing horizons. Because of these differences in riskreturn trade-off, correlations between assets are also very likely to change over time. This
presumption is confirmed by Hoevenaars, Molenaar, Schotman and Steenkamp (2007), who
show that there are horizon effects to be found concerning inflation and interest hedging
qualities of assets. While equity shows negative hedging qualities for inflation in the short
run, in the long-run the hedging power is much stronger. Hoevenaars et. al. (2007) further
show that alternatives such as hedge funds, commodities and credits have an added value in
risk diversification. The long-term correlations of variance swaps are therefore also shown
and discussed.
All in all, it can be concluded there may be considerable differences in the optimal portfolio
with or without liabilities considered, and with a short-term horizon or one with a longer
horizon. These two factors combined, show why an ALM study is the more appropriate
analysing tool in this particular research. It allows one to differentiate between long and short
term risks, long and short term correlations and provides a clear view of the interaction
between assets and liabilities.
- 33 -
The ALM model of ABP
The Asset Liability Management model of ABP uses historical data series as input. From
the historical data, all parameters such as returns, correlations and covariances for and
between all assets are estimated. The next step is that all parameters are adjusted to the
long-term views of ABP. However, the historical dynamics and volatility of the returns is
maintained. Then, 5000 scenarios are run for every year with a horizon of 15 years,
modelling all asset prices, interest rates and relevant inflations (wage/price). These
simulations are done using the long-term views and historical dynamics of all respective
assets. Finally, all results are put together per year, and a good overview of the
performance of the portfolio can be given. Often the average results are reported, although
occasionally the median is chosen instead to reduce the influence of outliers.
Unfortunately, no further information can be exposed due to the confidential nature of the
model and its calculations.
7.3.
FAIR VALUE
Until the late 1990s, and early 2000s, pension funds were not obliged to value their liabilities
on market or fair value. This enabled them to use a fixed percentage (4%) to discount their
liabilities without considering inflation or fluctuating interest rates. In 2007 this changed, as
the Nieuw Financieel Toetsingskader (nFTK) was introduced. This new regulatory framework
forces pension funds to use market-based valuation of their assets and liabilities. Also a
(short-horizon) solvency test was introduced. Since the change to fair value, pension funds
have to consider the increased liability risk as their liabilities now fluctuate along with the
interest or discount rate. They no longer only face investment risks on their assets, but also
have more volatile and therefore more risky liabilities.
7.4.
LIABILITY RISKS
Pension funds are under constant scrutiny of various supervisory institutions, which look at
the financial health of the fund. Generally, the funding ratio is their statistic of prime interest.
The funding ratio is simply defined as the ratio of all assets to all liabilities. Naturally, any
ratio consisting of two components can have two causes which influence its level. Not only
- 34 -
does a poor investment return deteriorate the funding ratio, an increase in liabilities has the
same effect. While in the past most funds ignored these risks, they have come to realise that in
fact liability risks are a major determinant of pension results. This awareness has gained
further strength when in the early 2000s both the equity markets plummeted and interest rates
decreased sharply. These two effects combined resulted in sharply decreasing funding ratios
and alarm bells ringing with every supervisor. This relatively new insight has lead to a shift,
or more exact, spread of attention which now also focuses on liability risks. Figure 6 shows
the funding ratio of ABP over the last 27 years, using the old (4%) discount rate.
12%
300%
10%
250%
8%
200%
6%
150%
4%
100%
4%-discount factor
50%
2%
Nominal funding ratio

Interest rate (right axis)
0%
0%
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06
Figure 6. Funding ratio of ABP.
The liability risks faced by a pension fund arise from its obligations towards current retirees
and future retirees. The first risk is the interest rate risk. This risk is in some way a new risk
for pension funds. As explained before, pension funds are now compelled to discount their
future liabilities with the nominal market interest rate instead of using a fixed rate. This
seemingly subtle difference has far-reaching consequences. If the interest rate decreases,
future liabilities are discounted at a lower rate, i.e. liabilities will go up and the funding ratio
will decrease.
In this perspective, the example of T-bills shows how significant this difference can be.
Hoevenaars et. al. (2007) show, that for an asset-only investor short-term T-bills are very
- 35 -
appealing because of their low risk. However, for an asset-liability investor short-term T-bills
are not that attractive. Because of their short-term nature, the asset-liability investor is faced
with a mismatch in his duration and low interest rate hedging qualities. This reduces their
overall attractiveness as an asset class in the ALM analysis.
The second main liability risk for pension funds is inflation risk. This risk stems from the
intent, usually not the obligation, of indexation of the pensions. Naturally, if inflation
increases, assuming full indexation, the current and future liabilities also rise. If this rise is not
matched in a growth of asset returns, it will have negative consequences for the funding ratio
of the pension fund.
A third major liability risk is longevity risk. This risk comes with increasing life-expectancies.
If a major medical breakthrough is realised, and people all live longer, this can have enormous
consequences for pension liabilities. As the pension is paid until the retirees decease, a longer
life will simply lead to higher costs. These risks can be hedged away through for instance
longevity bonds. However, due to the complicated relation between simple asset returns (and
volatilities), and longevity, it was chosen not to include this risk specifically in this paper.
All these things considered, an ALM study can yield very different outcomes from an assetonly study. As the ALM model considers liabilities as well as assets, any asset correlated to
the liabilities will be relatively attractive. For instance index-linked bonds, which are by
nature highly correlated with inflation, will probably be have a greater added value in an
ALM setting than from a standard asset-only point of view. Therefore, it is interesting to see
how variance swaps influence the outcomes of an ALM study.
- 36 -
8.
ALM Results
ALM RESULTS
In this section the results of the Asset-Liability Management (ALM) analysis will be
presented. The results discussed in the previous chapter were all based on historical data, and
took an asset-only perspective. Since ABP is a pension fund, it faces liability risks in the level
of their pension liabilities. These are ignored in the asset-only analysis. Furthermore, since the
asset-only perspective is based solely on historical results, the results might be flawed due to
an unrepresentative sample. In the sample just over 17 years of data is being used. Even
though these 17 years showed some periods of high volatility (end of the 1990s and early
2000s) and low volatility (2004-2007), they may not be representative and we cannot base all
conclusions on such a relatively short sample period. On top of this, the dynamics between
assets is hard to measure, and correlations can change in certain market scenarios. All these
reasons combined, give rise to the need of a more profound analysis of the results. Therefore
an ALM analysis was performed, using thousands of scenarios with a horizon of 15 years to
evaluate the performance of assets and strategies. The results per strategy will be discussed
using the outcomes of variables such as the pension result, funding ratio and mismatch risk.
All scenarios have been run with a weight of 5% of total assets, invested in the variance swap
strategy. Even thought a 5% weight is too large to be realistic, such a position provides more
insight into the dynamics than a, more realistic, 1% position. As the ALM model works with
quarterly data for asset returns, 3-month variance swaps are used instead of the 1-month
swaps used in the asset-only analysis. Naturally, the three month implied volatility is used,
which is simply referred to as VIX for sake of simplicity. In the analysis, the pension
contributions and indexation policy is not changed, in order to allow a fair comparison
between strategies. The performance of the strategy can be measured by comparing the
median of the pension result, and indexation results, while the probability of underfunding can
be considered the risk measure. The results from the optimal portfolio from the Strategic
Investments Plan (STIP) are given as a point of reference.
- 37 -
8.1.
ALM Results
STRATEGIC INVESTMENT PLAN (STIP)
The Strategic Investment Plan (STIP) is a three-year plan, determining the strategic
investment policy of ABP over these three years. The current plan runs from 2007 to 2009. It
defines two main investment priorities
Better alignment between returns of assets and the growth of liabilities.
Investments should focus more on the long-term, and on innovation and adaptation of
new investment strategies.
The STIP further states the expectation of a good economic outlook with stable growth and
relatively low inflation. Due to new regulations like the nFTK (Nieuw Financieel
Toetsingkader) the STIP portfolio needed some changes. A larger share of the portfolio will
be invested in real assets such as gold, and also the share directed toward inflation linked
bonds (ILB) will be increased compared with the previous STIP. These increases will come at
the cost of the share of fixed income. Finally, innovative strategies receive more attention in
the new STIP; for instance infrastructure is introduced as a new asset class. The Strategic
Investment Plan is the basis for the strategic asset mix. Using a range of criteria such as
mismatch risk, indexation possibilities and expected funding ratio, the best investment mix is
chosen. So the STIP portfolio is the optimal portfolio using the current assets and knowledge.
The portfolio consists of the following investments: 29% MSCI World Index, 23% 5-year
credits (corporate bonds), 11% Real Estate, 10%, 30-year government bonds, 7% Interest
Linked Bonds, 5% emerging market equity, 5% hedge fund index, 5% private equity 3%
Goldman Sachs Commodity Index, and 2% Convertibles (ABP, 2006).
8.2.
ALM OUTPUT EXPLAINED
In the ALM tables shown below, the first output variable is average return over 15 years. This
number shows the average return of all scenarios of the portfolio over the entire horizon of 15
years. Naturally, the average return is one of the statistics of highest interest. The funding
ratio is the median of all funding ratios of all scenarios. The funding ratio simply is the ratio
of assets to liabilities or
Total assets
. The reason why the median is reported and not the
Total liabilities
average is that the median, as opposed to the average, is not influenced by outliers. Therefore,
is provides a more realistic view of the expected funding ratio. The chance of underfunding is
shown with all the solvency risks, in the rows with P(F(T=..)<). Firstly, the chance that the
funding ratio drops below 100% within 1 year is shown. Also the chances that the funding
- 38 -
ALM Results
ratio is below 104.3 after both 1 and 15 years is reported. The ratio of 104.3 is chosen because
this is the level at which the regulator requires immediate actions and a rescue plan to get
the fund solvable in the short run. Apart from the chance of underfunding after a certain time
period, it is naturally also interesting to see how likely a one-time drop is. For this reason the
chance that the funding ratio drops below 100% somewhere in the coming 15 years is also
reported. If an asset is a good hedge, we expect this probability to decrease, since a crisis in
the financial markets would be less harmful.
One of the more important but less intuitive factors is the so-called mismatch risk. This factor
measures the standard deviation of the difference between the return on the assets and the
change in total value of the liabilities. In short: (Rassets Rliabilities ) . Clearly, a low mismatch
risk is preferable, since shocks in liabilities are copied with similar shocks in assets, leading to
a stable funding ratio. If the mismatch risk is high, it is likely that a rise in liabilities is not
matched with a similar rise in asset value, which would lead to a decreasing funding ratio
(Gaalen, 2004). Generally, this risk is higher in the short run (1 year) than in the long run (15
years). Also, a distinction is made between nominal returns and real returns, the latter being
corrected for inflation. Finally, the probability of indexation of pension liabilities is shown.
This first factor shows the chance that over the whole period the pension fund is able to fully
indexate its pension liabilities to wage inflation. Apart from the full indexation, also the
probabilities of partial indexation are stated. In the analysis, the current indexation policy of
ABP is maintained. All these variables are the major indicators used by ABP to examine an
asset class or strategy in ALM context. The outputs shown in this paper are also directly
retrieved from the model, and only a few indicators of lesser interested have been omitted.
8.3.
STRATEGIC INVESTMENT (STRATEGY I & II)
The first strategy to analyse is the strategic long position; the results are shown in Table 4. As
explained before, this means we take a long position every month no matter what the market
circumstances are. This is the position a risk-averse investor would take. However, as was
shown using historic data, this is a costly strategy. The results for this strategy and its opposite
are shown in Table 4 below.
- 39 -
Summary ALM statistics
ALM Results
STIP
STRATEGY I
STRATEGY II
Strategic long
Strategic short
Average return over 15 yr
0.06709
0.06336
0.07061
Funding ratio (median)
1.53473
1.45579
1.61281
P(F(t=1)<100)
P(F(t=1)<104.3)
0.0096
0.0214
0.004
P(F(t=15)<104.3)
P(Fnom<100) within 15yr
0.0248
0.066
0.0134
MMR 1yr Nom.
0.10225
0.10549
0.10028
MMR 15yr Nom.
0.05088
0.05314
0.05128
MMR 1yr Real
0.09341
0.09810
0.08999
MMR 15yr Real
0.05544
0.05733
0.05587
P(Full indexation)
0.7522
0.6544
0.8182
P(Indexation > 80%)
0,9628
0,924
0,9796
P(Indexation > 90%)
0,9154
0,8488
0,9426
P(Indexation > 95%)
0,8762
0,7976
0,9184
Table 4. ALM output of strategic variance swap investment.
The annual returns for the final year (15) from the ALM analysis are shown in a scatter plot
and a histogram in Figure 7. Every mark represents one of 5,000 scenarios that have been run.
Clearly, most returns are below the x-axis, indicating negative returns. As can be seen from
the output in the table, a 5% position in a long position reduces the average return with almost
0.4%. This may not seem very much, but with a horizon of 15 years and with the current
capital, this amounts to a difference in total assets of almost 30 billion! As can be expected
with a lower average return, the predicted funding ratio also deteriorates. It decreases from
153 tot 145 or about 8 percentage points. The lower overall funding ratio also increases the
chance of the funding ratio dropping below 104.3 after 15 years, the level at which the
regulator steps in and demands a stringent recovery plan. This probability more than doubles,
from 0.96% to 2.14%. So far these results were all in line of our expectations, as the negative
returns decrease the total average return and therefore funding ratio. These results may not be
ideal, but a long position can still be useful as long as the risk of sharp decreases of the value
of our portfolio will be decreased. Unfortunately this is not the case. Not only is the likelihood
of underfunding higher after 15 years, the probability that anywhere in the coming 15 years
the funding ratio drops below 100 also increases. With a 5% position in long variance swaps,
this chance increases from 2.48% to 6.60%. Again this is caused by the lower funding ratio,
which in turn is caused by the low returns. Even though we might have a hedge against the
worst crashes, due to its high price, the crash has to be less severe to still drop below the
100% funding ratio. Also the mismatch risk has increased after we take on the long position.
This is the case for both the nominal and real mismatch risk, and both in the long and short
- 40 -
ALM Results
term. Finally, the chance of full indexation decreases sharply from 75.2% to 65.4%. All things
considered it is safe to say that a strategic long position in a variance swap is not a very
sensible investment. As expected the position is very costly, but in return not much protection
is received. All risk factors considered in the model in fact suggest that the risks increase,
instead of decrease. This result is confirmed by Mougeot (2007), who show that the benefits
of diversification are too small, to make up for the enormous negative variance risk premium.
Figure 7. ALM scatter plot and histogram for a 3-month long variance swap (Strategy I). Vertical axis of the
histogram shows the number of observations x 100.
Since going long seems so unprofitable, taking a short position should give good results.
Again, a short position is taken in the variance swap regardless of the prevailing market
conditions. Since this is simply the opposite of the long position, it can be expected to find
- 41 -
ALM Results
opposite results. This expectation is confirmed by the results in Table 4. The average return
increases with approximately 0.35% per year. These higher returns also come back in the
higher funding ratio which increases with almost 8 percentage points. Also the chance of
underfunding decreases. The chance of underfunding in the long term decreases from 0.96%
to 0.4%, while the possibility of ever being underfunded in the coming 15 years decreases
from 2.48% to 1.34%. Another positive result is that the mismatch risk is reduced due to the
short position. Finally, the chance of full indexation increases with 1.5 percentage point. Even
though this result can be predicted because of the higher return and lower mismatch risk, the
data confirms this belief. All in all, taking a short position seems to be highly profitable. And
this profitability does not seem to come at the costs of much higher risks. Naturally there are
some months with large negative payoffs, but for a patient investor with a long-term horizon
such as a pension fund, these months are easily compensated on average.
The ALM model also calculates the long-term correlation between assets. As Hoevenaars et.
al. (2007) show, over a period of 20 years, correlations can change significantly leading to
different portfolio choices for different horizons. In Figure 8 below, the correlation of a long
variance swap is shown with some key variables. In the north-west quadrant, the correlation
between variance swap returns and the MSCI World index, or simply equity is shown. As
predicted and calculated before, it is negative at first. However, the hedging qualities of
variance swaps decrease somewhat with a decreasing negative correlation, but it remains
significantly negative. The correlation with fixed income in de north-eastern graph, however,
becomes positive after about 8 years. The graph of the correlation between the MSCI World
and fixed income is also shown (in the upper half of each quadrant), to stress the fact that they
are close to being mirror images. From the viewpoint of the liability risk, the correlation with
CPI (inflation) and the liabilities themselves are shown too. Again they seem to mirror the
correlation of the MSCI World. These graphs show very nice results as the correlation with
the CPI is positive, which means that when inflation, and therefore future liabilities, increases,
variance swaps will have a higher return. The same conclusion holds for the liabilities. These
results are not entirely in line with the expectations formed after the results presented in Table
4. As these correlations carry the sign hoped for (except in the case of fixed income), the poor
results from a long position are somewhat unexpected. However, it seems the variance risk
premium paid in the swaps is indeed too high to make a long position viable.
- 42 -
ALM Results
MSCI World
Fixed income
CPI
Liabilities
Figure 8. Long-term correlation of long variance swap returns.
8.4
DYNAMIC TRADING STRATEGIES
Apart from the strategic long and short positions, some more dynamic strategies are also
investigated in an ALM context. All results are shown in Table 5.
Summary ALM statistics
STIP
STRATEGY VI
STRATEGY VII
STRATEGY VIII
STRATEGY IX
15<VIX<30 Long
VIX<15 Short
VIX>30 Short
VIX<20 Short
VIX>30 Short
20<VIX<30 Long
VIX>25 Short
VIX<25 &
EQ<-5%
Long
VIX>20 Short
Average return over 15 yr.
0.06709
0.06143
0.06267
0.06908
0.07083
Funding ratio (median)
1.53473
1.41879
1.44374
1.58067
1.62237
P(F(t=1)<100)
P(F(t=1)<104.3)
P(F(t=15)<104.3)
0.0096
0.0234
0.0186
0.0066
0.0036
P(Fnom<100) within 15 yr
0.0248
0.0654
0.053
0.0188
0.0146
MMR 1yr Nom.
0.10225
0.10492
0.10199
0.10203
0.10131
MMR 15yr Nom.
0.05088
0.05036
0.04930
0.05151
0.05229
MMR 1yr Real
0.09342
0.09714
0.09254
0.09313
0.09226
MMR 15yr Real
0.05544
0.05478
0.05384
0.05608
0.05673
P(Full indexation)
0.7522
0.6216
0.6474
0.784
0.8182
P(Indexation > 80%)
0.9628
0.9098
0.9282
0.9752
0.9806
P(Indexation > 90%)
0.9154
0.8248
0.851
0.9334
0.9456
P(Indexation > 95%)
0.8762
0.7676
0.7922
0.9032
0.9206
Table 5. ALM output of dynamic variance swap investment.
- 43 -
ALM Results
The first dynamic strategy, Strategy VI is deemed a safe strategy in which a long position is
taken in most months. We go long when the VIX is between 15 and 30, and short otherwise.
As explained before, the basic idea behind this strategy is that when the VIX stands between
15 and 30 is it good to have protection from volatility risk and stock market crashes.
However, with the VIX on extremely high or low levels the protection is respectively too
costly or not necessary, so variance is sold to receive the premium and make up for the, on
average, more costly long positions. To sum up Strategy VI:
15 < VIX < 30
Long
VIX < 15
or
VIX > 30 Short
As can be seen from the table, the ALM results confirm the findings in an asset-only analysis:
this is not a very profitable investment strategy. The average return over 15 years decreases
with almost 60 bp and the median funding ratio decreases with 12 percentage points. As was
seen before with the strategic long position, it does not seem to reduce the risks significantly.
In the short run (1 year), both the nominal and real mismatch risk even increase. However, in
the long run (15 years) the mismatch risk decreases somewhat. Nonetheless, the risk of
underfunding increases quite dramatically. The chance that the funding ratio is below 104.3
after 15 years more than doubles, while the chance of ever being underfunded in the coming
15 years increases from 2.48% to 6.54%. Finally, as expected the possibility of full indexation
has decreased together with the forecasted pension result and average return. The chance of
full indexation decreases with over 13%, and also the partial indexation chances are reduced.
Figure 9 shows the scatter plot of the returns for the final year of the ALM analysis, with on
the x-axis the matching equities return. Looking at the graph it is obvious that this strategy
yields a negative return on average, as the majority of the returns lies below the x-axis. Also
note that this is definitely not a very safe strategy, with losses occasionally reaching levels of
over 200%. On the other hand there are some major gains to be observed too. The histogram
shows some positive skewness suggesting a relatively high chance for large gains.
- 44 -
ALM Results
Figure 9. ALM scatter plot and histogram for Strategy VI. Short when VIX>30 or VIX<15, long when
15<VIX<30. Vertical axis of the histogram shows the number of observations x 100.
The second dynamic strategy considered, Strategy VII is one that only takes short positions or
does not take any position. Again the choice depends on the level of the VIX. We use more or
less the same boundaries as in Strategy VI mentioned above; only now a short position is
already taken when the VIX goes below 20. We expect this strategy to have a positive payoff
since no long position is taken. The scatter plot for this strategy is shown in Appendix 12.A.
To summarise Strategy VII:
20 < VIX < 30
VIX < 20
or
No position is taken
VIX > 30 Short
- 45 -
ALM Results
Judging from the results our expectations are not fulfilled. Instead of an increase, the average
return in fact decreases with 31 bp. The drop of the median funding of 9% is also large. This
of course leads to increases in the chance of underfunding, which almost doubles. Again the
same pattern is observed that was visible in the asset-only context, namely that against
expectations, a short position seems to reduce the risk. The mismatch risk decreases both in
the short and in the long term. Naturally, due to the previous results, also the chance of
complete or partial indexation is decreased. All these results are not as bad as with Strategy
VI, but still come as a surprise, since taking a short position was deemed to yield positive
returns. Nevertheless, the scatter plot shows almost the same pattern as Strategy VI showed.
However, this time the pattern seems to move downward with increasing equity returns. Also
in the area with most observations, it seems that this strategy more often leads to relatively
large losses.
A variation to the previous strategy, with its poor performance in mind, is Strategy VIII.
Again, only short positions or no positions are taken. However, this time, only a short position
is taken when the market is nervous, and (on average) the volatility risk premium is high.
However, to at least have enough trades to draw some conclusions from, it is decided to lower
the boundary from 30 to 25. Please note that this strategy is a replication of Strategy V in the
asset-only analysis. Summarising Strategy VIII:
VIX < 25 No position is taken
VIX > 25 Short
As can be seen from the table, Strategy VIII obviously performs better than Strategy VII. The
average return over 15 years increases with 20 bp compared with the STIP, and also the
funding ratio increases. As a consequence, the chance of underfunding after or within 15
years also decreases, with approximately 1/3. These better results do not seem to come at the
costs of higher risks, as the mismatch risk is similar to the STIP. The one-year mismatch risk
is even somewhat lower, while the 15-year mismatch is slightly higher. Naturally, due to the
higher returns and similar risk, the possibility of indexation increases. The chance that over
the period of 15 years, full indexation was offered increases from 75.2% to 78.4%. Naturally,
the chances of partial indexation increase as well. As can be observed in the scatter plot in
Figure 10, this strategy indeed does not lead to a high trading activity, which was already
concluded for Strategy V in an asset-only context. But this does not seem to be very harmful,
as most trades result in a positive payoff. Especially interesting is that the negative returns are
in the region where equity returns are highest and it is least harmful. Also, the risks seem
- 46 -
ALM Results
quite low, since the largest loss is 100%, which is a relatively small loss compared with some
scatter plots observed earlier. The histogram confirms this graphical analysis. Naturally, there
is a peak at 0%, for all the months in which no trade was made. However, apart from this,
most returns are positive and only very few negative returns are observed.
Figure 10. ALM scatter plot and histogram for Strategy VIII. Short when VIX>25. Vertical axis of the histogram
shows the number of observations x 100.
The last dynamic strategy, for which an ALM analysis is performed, Strategy IX, is somewhat
more complicated and different from the previous strategies. This strategy does not base its
decisions on the level of the VIX. Instead, the VAR-model of ABP is used to make a
prediction for equity returns. If the stock return forecast is below -5% for the next quarter, the
volatility will probably be high and a long position is taken. However, this is only done when
- 47 -
ALM Results
the VIX is below 25. If it would be above 25, the low expected stock returns (and thus high
volatility) seem to be incorporated in the price of the swap, and therefore reduce its
attractiveness. On the other end of the spectrum we can take a short position. This is done
when the VIX is at least 20 and the forecasted stock returns are not lower than -5%. The same
(but opposite) logic applies, if expected returns are high, or at least not too low, volatility is
probably low, and a short position is profitable. But again, only when the VIX is high enough,
because otherwise the low volatility seems to be calculated in the strike of the variance swap.
This strategy obviously tries to specifically select the months in which a long position is
profitable, and go short only when it is safe to do so.
Expected return on stocks
Expected return on stocks
< 5% and VIX < 25 Long

> 5% and VIX > 20 Short
Judging from the table it seems this strategy definitely has its merits. It shows the highest
average return, which is almost 30 bp higher than in the STIP portfolio. Naturally, the funding
ratio increases quite spectacularly, from 153 to 162. However, these nice returns do come at a
cost: the long-term mismatch risk increases. The 1-year mismatch risk is still quite similar to
the STIP portfolio and actually slightly lower, but the long-term mismatch risk increases with
over 1 percentage point, in both nominal and real terms. This effect can be caused by many
things, such as a sudden interest rate increase, leading to a decrease of liabilities but an
increase in returns on assets, hence and increase of the mismatch risk. On a more positive
note, due to the higher average returns, the chance of underfunding after 15 years is reduced
to nearly 1/3 of its original size. Also the chance of the funding ratio dropping below 100
within the coming 15 years decreases from 2.48% to 1.46%. Naturally, together with the
improved returns, the chance of complete indexation will increase. The table shows that this
chance actually increases with over 6%.
Just like with Strategy VIII, the scatter plot shows the good payoffs. The majority of returns
are (slightly) positive, while the outliers are generally in the area where equity returns are
highest. Also the number of extreme negative returns is reduced, especially compared with
Strategies VI and VII. It seems that using the VAR model to predict equity returns, we can
better time the market and determine what position we should take. This timing provides us
with good returns, and with relatively few risks. The histogram shown in Figure 11 is quite
- 48 -
ALM Results
similar to Strategy VIII, although this peak is not as extreme since Strategy VIII leads to
much more trades.
Figure 11. ALM scatter plot and histogram for Strategy IX. Long when expected equity return is <-5% and
VIX<25. Short when expected equity return >-5%, and VIX>20. Vertical axis of the histogram shows the
number of observations x 100.
All in all, the results found in an asset-only context are confirmed by the ALM study. It seems
that a strategic long position in variance swaps is not too costly, while a short position is
much more appealing. Also, it is shown that dynamic trading can improve the risk-return
profile of variance investing.
- 49 -
9.
Future research
FUTURE RESEARCH
The market for volatility derivatives is growing at a rapid pace, and with that new products
enter the market every day. In this part, some other methods of trading volatility will be
shortly explained, and some suggestions for further research will be made.
Naturally there are other methods of trading volatility than the ones explained before. A new
strategy, for instance based on the economic climate could provide entirely different results.
In this paper a fixed amount of money is constantly assigned to volatility investments.
Perhaps a strategy in which the number of contracts depends on the level of the VIX would
yield far superior results. Furthermore, this paper focuses solely on 1- and 3-month variance
swaps. Naturally, a longer term variance is less volatile (the volatility of volatility is lower),
so the chance of extreme differences between the implied and realised volatility is decreased.
It can be expected that a lower risk premium is required to enter the swap. This expectation is
confirmed by Mougeot (2007) who shows that variance swaps with longer maturities yield
superior results. Also, forward starting variance swaps are shown to perform much better than
1-month variance swaps.
A further variation lies in the possibility of putting a cap to the variance swap. This cap is
generally placed at 2,5 times the strike variance. If the volatility strike is 20, this would result
in a maximum loss of (502-202)*Notional, even if the realized volatility is above higher than
50%. Through this cap, the seller of the contract is protected against extreme jumps in realised
variance. However, the level of 2,5 times the strike volatility is only once exceeded (July
2002) in the database used in this paper, and indeed proves to be rarely necessary (Mougeot,
2007; Windcliff, Forsyth, & Vetzal, 2003).
Another aspect of volatility investments is which type of volatility is traded on. For instance,
the mark-to-market value of a normal variance swap is a mix of the realized and implied
variance. As the swap approaches maturity, the exposure to realised volatility will increase
while the exposure to implied volatility will decrease (Allen, 2004). Conversely, the mark-tomarket value of forward-start variance swap depends on the implied variance only, until the
start date. A forward-start variance swap obliges its possessor to enter the variance swap on a
- 50 -
Future research
later pre-defined date. Therefore, using forward-start variance swaps, an investor can gain
exposure to implied variance, and selling them before the initiation date (Mason, Varsani, &
Sharaiha, 2007). It was shown that a long position in forward-start variance swaps is both
profitable and a good diversifier. Especially a 6-month forward-start swap with a maturity of
6 months performed well (Mougeot, 2007).
Conditional variance swaps as the name suggests, provide exposure to variance under certain
conditions. This condition generally is a pre-specified range in which the underlying should
move, for the swap to become active. An upside range means the investor only gains exposure
to the volatility if the underlying asset exceeds a barrier level. These swaps can be
advantageous when the investor has specific ideas on which direction the market or
underlying is going to move (Mason, Varsani, & Sharaiha, 2007). Corridor variance swaps are
similar and provide exposure to the underlying assets volatility as long as it is exchanged
within a pre-set corridor. Gamma swaps are analogous to normal variance swaps, except that
the exposure to volatility increases as the underlying asset increases, and decreases when it
drops. Another possible innovation might be the introduction of options on straddles. Brenner,
Ou and Zhang (2006) show that this investment vehicle would have a direct exposure to
volatility and is cost efficient.
So far, all volatility trading was based on equity volatility. However, there are other types of
underlying assets possible. Currencies for instance have a highly active volatility swap market
(Houweling, 2007). Furthermore, Mortgage Backed Securities (MBS) provide investors with
a platform for interest rate volatility trading. Mortgage Backed Securities have an embedded
option, namely the fact that they can be refinanced when mortgage rates are low. Refinancing
of mortgages is a risk for investors as it decreases the value of the fixed income of the bond
since it generally happens when interest rates are decreasing. Therefore, the payoff is similar
to a short position variance swap; stable income in times of stability but decreasing returns
when the interest rate drops. This risk of prepayment naturally comes at a premium, which
can be captured by investors. This premium is shown to be quite profitable. The risk is that
when interest rates are declining, also the duration of the MBS will decline as more people
will refinance their mortgages. Therefore, the duration is uncertain and might move in
undesired directions. Therefore, MBS can be used speculation purposes of the direction of the
changes of mortgage rates (Wands, 2003).
- 51 -
Future research
These are just some possibilities of investments in (any form of) volatility. Most of these
investment vehicles have sprung up recently and therefore not much research has been done
regarding the investment possibilities for pension funds.
- 52 -
10.
Conclusion
CONCLUSION
In this paper some examples of volatility investing have been examined. The volatility of
equity returns is generally one of the largest risks for investors. This risk presents itself as an
increase in transactions costs or a higher tracking error in times of increased volatility.
Volatility derivatives such as futures, options or swaps, can provide a hedge against these
risks. Furthermore, these instruments can hedge some of the risk of a stock market crash as
well, due to the strong negative correlation that exists between volatility and variance. Since
these derivatives provide such insurance, it can be assumed that they come at the cost of a
premium. It was examined whether this premium is worth its money.
In order to find an answer to this question, first the difference was made between volatility
and variance, as variance is the square of volatility. Because volatility options and futures
have become available only the last few years, variance swaps are the only asset considered in
this paper. In order to find the payoff of a variance swap, first the strike volatility must be
determined. This was taken from the Volatility Index (VIX); an index constructed through
options, showing the implied volatility of the S&P 500 for the coming 30 days. Consequently,
the realized volatility is calculated for a 1-month period. The difference between the implied
and the realized volatility provides us the returns on the swap.
As expected the returns on a long position in a variance swaps are negative. This is simply the
premium that needs to be paid to hedge away the volatility risk. However, this premium is
very high, 3.7% per month! Add to this that the protection against stock market crashes does
not seem to be spectacular and the conclusion is easy that this is not a good investment. The
reason for this poor performance is that if a stock market decrease is expected, the implied
volatility will increase and the variance swap will still yield a negative return. It is only in
unexpected events like 9/11, that the variance swap provides solid protection. On the other
hand, a short position in a variance swap turns out to be very profitable. Some market timing,
using the level of the VIX as a signal, turns out to be fairly profitable as well. If done really
well, a short position in the majority of the months is completed with a long position or no
position at all, in the months where realized volatility is higher than expected.
- 53 -
Conclusion
Apart from this historical analysis, also an ALM study was performed. For this swaps with a
maturity of 3-months were used. This study shows the interaction between variance swaps
and the liabilities of the pension fund. Again, it is shown that a short position is preferable in
comparison with a long position. The long position reduces the overall returns without
significantly lowering the risks. Also in an ALM context it can be proven that dynamic
trading has benefits. Especially a strategy based on the forecasted equity returns provides
relatively stable and positive returns.
All in all, it can be concluded that variance swaps are an interesting asset for pension funds
and other investors. However, using variance swaps as a strategic hedge is simply too costly
to be sensible for a long-term investor. A long position therefore only seems attractive for a
short-term investor or when speculating on an increase of the volatility. If the investor is
willing to take on some extra short term risk, he or she can make large profits by going short
in variance swaps. If some market timing is used, it seems these returns can even be
enhanced. It is further shown that also in an Asset-Liability Management view, these
conclusions hold. Naturally, this is only one type of volatility investment, but it does show
that the fast growth of the derivative market can provide interesting new assets for investors.
- 54 -
11.
References
REFERENCES
ABP. (2006). Strategic Investments Plan 2007-2009. Heerlen: ABP.

Allen, P. (2004). Variance swaps. Risk, 17(8), 51-52.
Amounts outstanding of over-the-counter (OTC) derivatives by risk category and instrument.
(2006). Basel, Switzerland: Bank for International Settlements. Retrieved May 16,
2007, from the World Wide Web: http://www.bis.org/statistics/derstats.htm
Bakshi, G., & Kapadia, N. (2003). Delta-Hedged Gains and the Negative Market Volatility
Risk Premium. Review of Financial Studies, 16(2), 527-566.
Bondarenko, O. (2004). Market Price of Variance Risk and Performance of Hedge Funds.
Unpublished manuscript, University of Illinois, Chicago.
Brenner, M., Ou, E. Y., & Zhang, J. E. (2006). Hedging volatility risk. Journal of Banking &
Finance, 30(3), 811-821.
Campbell, J. Y., & Viceira, L. M. (2005). The Term Structure of the Risk - Return Trade-Off.
Financial Analysts Journal, 61(1), 34-44.
Carr, P., Madan, D., Jouini, E., Cvitanic, J., & Musiela, M. (2001). Towards a Theory of
Volatility Trading. In Option pricing, interest rates and risk management (pp. 458476): Cambridge University Press.
Carr, P. P., & Wu, L. (2004). Variance Risk Premia. Unpublished manuscript, New York.
Demeterfi, K., Derman, E., Kamal, M., & Zou, J. (1999a). A Guide to Volatility and Variance
Swaps. Journal of Derivatives, 6(4), 9-32.
Demeterfi, K., Derman, E., Kamal, M., & Zou, J. (1999b). More than you ever wanted to
know about volatility swaps. New York: Goldman Sachs, Quantitative Strategy
Research Notes.
Derman, E., & Kani, I. (1994). The Volatility Smile and its Implied Tree. New York: Goldman
Sachs, Quantitative Strategy Research Notes.
- 55 -
References
Gaalen, R. v. (2004). Pension funds: Funding index, mistmatch risk premium and volatility:
Watson Wyatt Brans & Co, paper presented at the International AFIR Colloquium,
Boston, 2004.
Goetzmann, W. N., Li, L., & Rouwenhorst, K. G. (2005). Long-Term Global Market
Correlations. Journal of Business, 78(1), 1-38.
Hoek, H. (2007). Alternatives vanuit een ALM perspectief. VBA Journaal(1), 6-11.
Hoevenaars, R. P. M. M., Molenaar, R. D. J., Schotman, P. C., & Steenkamp, T. B. M.
(2007). Strategic asset allocation with liabilities: beyond stocks and bonds, LIFE
working paper, Maastricht University.
Hosker, J. J., & Dholakia, A. (2004). Variance and Volatility Swaps, in Equity derivatives
research, Lehman Brothers, New York.
Houweling, P. (2007). Trading FX Volatility Swaps. Paper presented at the Investing and
Trading in Volatility, London, 2007.
Hull, J. C. (2005). Fundamentals of Futures and Options Markets (5th ed.). Upper Saddle
River: Pearson Prentice Hall.
Leippold, M., Egloff, D., & Wu, L. (2006). Variance Risk Dynamics, Variance Risk Premia,
and Optimal Variance Swap Investments. Unpublished manuscript.
Lighaam, P. (2006). The Strategic Use of Variance Swaps in a Pension Fund Portfolio,
Global Pensions Quarterly, Morgan Stanley, New York.
Markowitz, H. M. (1976). Markowitz Revisited. Financial Analysts Journal, 32(5), 47-52.
Mason, C., Varsani, H., & Sharaiha, Y. (2007). Strategic and Tactical Applications of New
Volatility Products. Paper presented at the Investing and Trading in Volatility,
London, 2007.
Mougeot, N. (2007). Volatility as an Asset Class, Technical Report from Equity Derivatives
Strategy Group, Deutsche Bank, London.
Neuberger, A. (1994). The Log Contract. Journal of Portfolio Management, 20(2), 74-80.
- 56 -
References
Ramchand, L., & Susmel, R. (1998). Volatility and cross correlation across major stock
markets. Journal of Empirical Finance, 5(4), 397-416.
Sulima, C. L. (2001). Volatility and Variance Swaps (pp. 1-4), Capital Market News, Federal
Reserve Bank of Chicago.
VIX CBOE Volatility Index (2003), Chicago: Chicago Board Options Exchange. Retrieved
March 29, 2007, from the World Wide Web:
http://www.cboe.com/micro/vix/vixwhite.pdf
Wallmeier, M., & Hafner, R. (2006). Volatility as an Asset Class; European Evidence:
Risklab Germany, Unpublished Document.
Wands, M. (2003). The case for U.S. Mortgage-Backed Securities for Global Investors.
Retrieved June 15, 2007, from the World Wide Web:
http://www.ssga.com/library/esps/caseforusmortgagebackedsecurities20030228/page.h
tml
Whaley, R. E. (1993). Derivatives on market volatility: Hedging tools long overdue. Journal
of Derivatives, 1, 71-84.
Whaley, R. E. (2000). The Investor Fear Gauge. Journal of Portfolio Management, 6, 12-17.
Windcliff, H., Forsyth, P. A., & Vetzal, K. R. (2003). Pricing Methods and Hedging
Strategies for Volatility Derivatives. Journal Banking Finance, 30(2), 409-431.
- 57 -
12.A.
Appendix A
HISTORICAL PERFORMANCE OF ALL STRATEGIES

Strategy
I
Average return
Standard deviation of return
Skewness of returns
Kurtosis
Number of months Long position
Number of months Short postion
Total months active position
(max. 207)
Minimum return
Maximum return
Average return Long position
Average return Short position
Performance in months with
highest realised volatility
Performance in months with
lowest returns on S&P 500
Active positions in worst 10
months (max. 10)
Number of months with positive
payoff within worst 10
II
III
-3.73%
4.06%
1.96
8.94
207
0
207
3.73%
4.06%
-1.96
8.94
0
207
207
0.94%
5.44%
-0.74
0.59
83
124
207
1.18%
5.39%
-0.07
0.13
71
136
207
5.53%
6.18%
-2.49
10.00
0
34
34
-13.39%
21.25%
-3.73%
n/a
13.09%
-21.25%
13.39%
n/a
3.73%
-13.09%
-21.25%
10.55%
-3.47%
3.89%
-13.09%
-10.55%
21.25%
-3.72%
3.73%
13.09%
-21.25%
13.39%
n/a
5.53%
-21.25%
-0.51%
0.51%
-0.26%
-0.40%
1.94%
10
10
10
10
- 58 -
IV
12.B.
Appendix B
SCATTER PLOTS & HISTOGRAMS
Figure A.1. ALM scatter plot and histogram for a short variance swap (Strategy II). Vertical axis of the
histogram shows the number of observations x 100.
- 59 -
Appendix B
Figure A.2. ALM scatter plot and histogram for Strategy VII; short when VIX<20 or VIX >30, long when
20<VIX<30.
- 60 -

Variance Swaps For Pension Portfolio

Hochgeladen von

Dokumentinformationen

Originaltitel

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Variance Swaps For Pension Portfolio

Hochgeladen von

Copyright:

Verfügbare Formate

VARIANCE SWAPS IN A

PENSION FUND PORTFOLIO

Variance swaps in a pension fund portfolio

VOLATILITY ........................................................................................................................................- 5 2.1.

VOLATILITY INVESTMENT USING OPTIONS ...................................................................................... - 6 -

VOLATILITY SWAPS...........................................................................................................................- 9 3.1.

ASSET-LIABILITY MANAGEMENT .............................................................................................. - 31 7.1.

ALM RESULTS ................................................................................................................................... - 37 8.1.

FUTURE RESEARCH ........................................................................................................................ - 50 -

HISTORICAL PERFORMANCE OF ALL STRATEGIES................................................... - 58 -

SCATTER PLOTS & HISTOGRAMS..................................................................................... - 59 -

Variance swaps in a pension fund portfolio

Variance swaps in a pension fund portfolio

Variance swaps in a pension fund portfolio

Variance swaps in a pension fund portfolio

Variance swaps in a pension fund portfolio

Monthly volatility of the S&P 500

Figure 1. Monthly volatility of S&P 500 returns.

VOLATILITY INVESTMENT USING OPTIONS

Variance swaps in a pension fund portfolio

Variance swaps in a pension fund portfolio

Variance swaps in a pension fund portfolio

Variance swaps in a pension fund portfolio

Variance swaps in a pension fund portfolio

VARIANCE AND VOLATILITY SWAPS

Variance swaps in a pension fund portfolio

The cash flows of a variance swap at maturity

Exhibit 1. Cash flows of a variance swap.

is therefore directly linked to the realised

Variance swaps in a pension fund portfolio

Volatility increases in times of uncertainty and high risks, providing a hedge

for risk-averse investors, or another speculation possibility for others.

Volatility is mean-reverting; low volatilities are expected to rise and high

Variance swaps in a pension fund portfolio

VOLATILITY VS. VARIANCE SWAPS

Volatility and variance swap returns

Variance swaps in a pension fund portfolio

PRACTICAL APPLICATIONS OF VARIANCE SWAPS

Variance swaps in a pension fund portfolio

Variance swaps in a pension fund portfolio

Variance swaps in a pension fund portfolio

Calculation of the Volatility Index

VIX/100 (or VIX = * 100)

The time to expiration

Q(Ki) The middle of the bid-ask spread for option Ki

The first strike below the forward index level F

(VIX CBOE Volatility Index, 2003)

Variance swaps in a pension fund portfolio

The realised variance is calculated in the following way:

To calculate the yield on variance swaps Formula 1, return =

is used. The input for

Variance swaps in a pension fund portfolio

Variance swaps in a pension fund portfolio

BASIC INDICATORS LONG AND SHORT STRATEGY

Variance swaps in a pension fund portfolio

Figure 4. Implied and realised volatility of S&P 500.

STRATEGIC INVESTMENT (STRATEGY I & II)

Variance swaps in a pension fund portfolio

Figure 5. Long variance swap return (1 month).

Variance swaps in a pension fund portfolio

Variance swap return

Variance swaps in a pension fund portfolio

Variance swaps in a pension fund portfolio