Strategy Spotlight

By: Scott Maidel, CFA, CAIA, FRM, Senior Portfolio Manager Sylvia Perek, Portfolio Manager May 2011

Variance Swaps for Absolute Return or Equity Replacement

Increased risk aversion has led to a systematic repricing of risk as measured by options markets. Post global financial crisis, this repricing is directly evident in the increased implied-to-realized volatility spread. Over the past two years this spread has consistently traded fifty percent higher than its long term average (see Exhibit 1). A simple way to think about this phenomenon is in terms of the demand for hedging long equity portfolios: insurance premiums for these portfolios have risen, but the investment risk as measured by the implied-to-subsequent realized volatility has remained steady. For those investors who believe this difference between implied and realized volatility will persist, a direct way exploit this relationship is with a variance swap. In the broader portfolio context, short variance strategies can be viewed as equity replacement or as a potential source of absolute return. They can also provide an attractive risk-adjusted, diversifying return stream. In this note, we review variance swaps, specifically covering the benefits, risks and common construction techniques. Exhibit 1: S&P 500 Implied to Subsequent 30-day Realized Volatility Spread as a Ratio
Impliedvs.RealizedVolatility
350% %Premium(Imp/realized) 300% %PremiumAverage 250%

200%

150%

100%

50%

0%

50%

100%

Source: Russell Investments, Bloomberg. Jan 1990 to Dec 2010. Standard & Poors Corporation is the owner of the trademarks, service marks, and copyrights related to its indexes. For illustrative purposes only. Data is historical and not a guarantee of future results.

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Common uses and benefits of variance swaps

Expressing a view on Volatility: A straightforward way to express a view on implied volatility relative to anticipated realized volatility. Hedging: Long variance can be used to hedge long exposures since volatility rises and generally remains elevated during times of market distress. Long variance may also benefit from periods of decreased market liquidity. Diversification: The systematic return capture in a short variance strategy can act as a diversifying risk premium within a portfolio. Equity Replacement: Sized appropriately, short variance can be used as an equity replacement.

Definition and simplified mechanics

A variance swap is an over-the-counter instrument intended to capture the difference between implied and realized volatility. Two parties agree to exchange cash flows based on the realized variance of the underlier over the life of the swap. The size, tenor, and strike price are set at the initiation of the swap. The strike is based on forward looking or implied volatility and serves as the reference level for the exchange of cash flows. The buyer of a variance swap will profit when realized volatility is higher than implied volatility. Conversely, the seller of a variance swap will profit when implied volatility is higher than realized volatility. Based on historical spreads, the seller will show profits over most time periods by capturing the imbedded risk premium, but will incur losses when realized volatility spikes and remains above implied strike over the tenor of the swap. Historically, the traditional way to isolate volatility exposure was through options. The drawback with options was hedging the directional exposure that options introduced. One of the elegant features of the variance swap is the absence of this delta risk. The payout is dependent only on the underlying volatility and not on the direction of the market.

Why variance and not volatility?

While volatility is the more common term used in the marketplace and the media to describe the risk of an assets price over time, market convention dictates the use of variance in the swap market. As one may suspect, the ultimate reason is dealer hedging. Dealers in volatility product hedge exposure in variance terms because variance swaps are more straightforward to hedge, value and ultimately unwind. The increased efficiency of the dealers ability to hedge their position translates into more efficient pricing passed on to the end user. See the Appendix for more detail on pricing and hedging.

Overview of sizing and structuring

Variance swap exposure is most often expressed in terms of vega notional. Vega notional is the dollar value per volatility point and represents an average profit/loss for a 1% change in volatility. The larger the vega notional the more dollar exposure one has to changes in volatility. Another important structuring element for short holders is the cap. Since short variance swap exposure has a theoretical unlimited downside, investors often utilize caps to limit losses. A capped variance swap limits losses to X times the strike. For example, a variance swap with a 2x cap struck at 17.5 would limit subsequent realized volatility marks to 35.0. Exhibit 2 shows the dollar performance of several short 1-month variance strategies versus a $100 million position in the S&P 500 total return index (SPTR). Vega notional exposures can be sized to replicate low volatility equity (S&P 500 Volatility Arbitrage Index and the $333 vega notional uncapped swap). Alternatively, vega notional positions can be sized with higher risk budgets to target higher payoffs ($1 million vega notional 2x capped and uncapped).

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Exhibit 2: Historical Performance (12/31/95- 3/7/11)

Uncapped Capped Variance Variance 2.41 1.92 3.55 2.94 16.17 15.67 -107.87 -80.21 7.96 6.51 7.56 6.98 -2.71 -3.60 80.2% 76.9% SPTR 0.71% 1.20% 14.14% -55.25% 5.28% 6.01% -5.43% 60.99% 333k Vega SPARBV Uncapped 0.8 0.6% 1.18 1.0% 5.39 5.0% -35.96 -33.8% 2.65 2.6% 2.52 2.2% -0.90 -1.2% 80.2% 79.1%

Average Median Max Monthly Gain Max Drawdown St Dev 90th Percentile 10th Percentile % of Months +positive

Source: Goldman Sachs. Standard & Poors Corporation is the owner of the trademarks, service marks, and copyrights related to its indexes. For illustrative purposes only. Data is historical and not a guarantee of future results. Indexes are unmanaged and cannot be invested in directly.

SPTR S&P 500 Total Return - Starting value $100 million SPARBV S&P 500 Volatility Arbitrage Index Starting value $100 million 333 thousand Vega Notional Uncapped 1 million Vega Notional Capped at 2x Strike 1 million Vega Notional Uncapped

Final considerations
Systematic short variance positions can be a valuable tool in the investors toolkit. Variance swaps trade on a wide variety of indices and global underliers. They represent a straightforward way to capture the implied-to-realized volatility risk premium. From a portfolio view, this strategy can provide diversification benefits within the equity bucket. It can also be viewed as an absolute return strategy within the alternatives bucket. In addition, short variance swaps can be used tactically to express a view on volatility or a long variance position can be an effective tool to hedge a downside move. The exposure management provider can advise on additional advantages and disadvantages associated with each scenario and tailor the desired exposures to a specific investment situation.

Appendix
Like many derivatives products, the pricing and hedging of a variance swap ultimately depends on the construction of a replicating portfolio. For a variance swap, this portfolio consists of an appropriately weighted strip of option contracts across varying strikes. This is not possible for volatility due to the way in which volatility scales with time - variance scales directly with time, volatility scales with the square root of time. In general, the replicating

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hedge is designed to render the vega exposure constant across different option strikes. By weighting the number of options according to the inverse of the strike squared, a constant vega profile can be achieved and the swap exposure is hedged. Pricing a variance swap is an exercise in computing the weighted average of the implied volatilities of the options required to hedge the swap. Therefore, the variance swap strike price is set so as to reflect the aggregate cost - in implied volatility terms - of the hedge portfolio.

Short variance swap payoff with a strike price of 25%, unit amount of 50,000.
Source: derivativesstrategy.com. For illustrative purposes only. Data is historical and not a guarantee of future results.

The graph highlights an important property of a variance swap: the payoff is nonlinear. For example, a realized volatility outcome two percent above the strike price has a larger (negative) payoff than a 2 percent realized volatility outcome below the strike price. For small deviations from the strike price, this negative convexity is generally insignificant, however when realized volatility is materially different from the strike price the payoff differences can be significant.

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