**The risk factors**

__Volatility__

Although many users of derivatives have a market direction mindset, the most important pricing parameter to the derivative specialist is volatility. To price an option, a trader must assume a level of volatility for the underlying instruments over the life of the option. Turning this on its head, quoted option prices therefore imply an expectation as to the level of volatility over the life of the specific contract. Knowing what the market expects, i.e. what is embedded in the price, allows a view to be taken relative to this expectation. Whereas traditionally expressing a volatility view required the trading of plain vanilla options and hedging of the resulting delta risk, it is now common practice to use a simple over-the-counter (OTC) contract for difference to achieve exposure solely to the difference between implied volatility and realised volatility. In practice such a contract trades the square of volatility, variance, as such a contract can be readily hedged (replicated) using plain vanilla options. However, the principle remains that the only determinant of the contract’s terminal value is the spread between realised volatility and the initial strike.

A common complaint levelled at volatility trading is that the positive benefits of being long realised volatility are offset by long periods of negative carry. That is, typically implied volatility is greater than realised volatility resulting in a steady drip-feed of losses. Conversely the skewed nature of the return distribution makes a simplistic, continuously short volatility strategy unappealing especially as such events are highly correlated with periods of poor performance from other asset classes. The key to successfully trading volatility is to be opportunistic, to remain flexible and to employ the full range of available instruments. Although taking an outright directional view on volatility remains a key driver of returns, it is important to recognise that implied volatility has both a term structure and a cross-sectional or skew structure. So, just as it is possible in the world of fixed income to take relative positions on the curve, the same remains possible in the world of volatility. For example, a short spot volatility position (implied versus realised) can be hedged by a long forward start volatility position further along the curve.

The presence of skew (implied volatility varying by strike for the same underlying and tenor) also offers opportunities to profit from anomalies. The presence of skew also suggests that volatility is itself something that exhibits volatility, so called vol-of-vol. This then opens the door to trading options on volatility itself. The volatility surface routinely offers opportunities to those who systematically analyse its characteristics and evolution. Unlocking these opportunities often involves returning to the roots of volatility trading, i.e. the trading of plain vanilla options and futures.

Volatility trading does not have to be solely an index orientated activity. Single stock (largest cap) volatility trading is also possible, primarily through plain vanilla options. This opens up the opportunity to construct a portfolio of long and short volatility positions on single stocks which results in a zero net volatility exposure in the same way that a long/short stock trading fund results in a zero net market exposure. The returns are then a function of the manager’s ability to buy cheap stock volatility and sell expensive stock volatility.

Dividends

The implied dividend market has developed significantly since F&C first traded a dividend swap in the late 1990s. Then a novel, innovative development, the dividend swap can now be traded as an exchange traded future and is increasingly done so by investors from hedge funds to pension funds. The listing of a derivative instrument immediately removes all the complexities associated with trading OTC such as counterparty risk and the need for specific legal documentation.

The dividend market is primarily index orientated (although single stock dividend swaps do trade and are becoming increasingly liquid) and, in Europe, is now the primary market for trading dividend risk. The dividend curve consists of a strip of discrete calendar years and the market is quoted in terms of the number dividend points the underlying index is expected to pay in aggregate over the calendar year.

Fig.1 shows the price evolution of three dividend contracts on the DJ Euro Stoxx 50. A cross section of the contracts at any given date provides the term structure of dividends for the given underlying index (see Fig.2). The market allows investors to take a view on dividends relative to that expected by the market.

It is worth undertaking a quick historic review of a market that has gone through a number of phases. The market was originally of great interest because it traded in backwardation, that is the market expected future dividends to be below today’s dividend level and more so with each successive year. In curve parlance the term structure was inverted and this was counter-intuitive as absolute dividends tend to grow over time offering a potentially attractive return. From 2005 onwards the curve initially flattened and then steepened as hedge funds and proprietary trading desks turned their attention to the market. Fuelled by real dividend growth, market participants aggressively accumulated significant positions along the curve. The onset of the credit crunch, subsequent dramatic economic slowdown and hedge fund deleveraging resulted in a panic to exit the trade. Dividends collapsed to levels of a genuinely distressed asset only partially supported by the fact that many financial companies had to cut dividend payments.

As risky assets generally rallied from their lows of early March 2009, dividends also received renewed attention and enjoyed a powerful rally outperforming the underlying cash market.

An accusation levelled at the so called dividend trade is that it is too highly correlated with the underlying equity market and certainly there have been periods when this has been the case. However, within a multi-strategy approach it is a fairly simple proposition to reduce this risk by implementing an option based hedge on the underlying spot market e.g. purchase a put spread.

__Correlation__

The volatility of an index is a function not just of the volatility of the component stocks of that index but also the level of correlation between those stocks. Therefore the implied volatility of an index is a function of both the implied volatility of the component stocks and the implied correlation between those stocks. In other words, the derivative market allows you to observe the market’s expectations for the level of future correlation and the existence of correlation swaps and dispersion swaps allow investors to express a view relative to this market expectation. The level of implied correlation, that also has a term structure, is driven by the relative levels of index volatility and single stock volatility. Therefore flows in each segment of the market will impact the implied correlation e.g. a ready supply of single stock volatility combined with demand for index volatility must result in implied correlation increasing. Implied correlation is also driven by the issuance of structured product that often leaves structuring desks within banks (exotic desks) short correlation resulting in general demand for correlation. The end result is that implied correlation can often trade rich relative to realised correlation, suggesting that a trade in which implied correlation is sold against future realised correlation might be attractive (see Fig. 3). Such trades are, by nature, longer term (six to 18 months) and implementation is typically opportunistic i.e. taking advantage of short term demand and supply imbalances.

**Structuring a portfolio**

The approach taken by F&C is to build a portfolio that is multi-strategy, in that it aims to gain exposure in a number of different ways to the risks described above. The focus is then on allocating risk capital across the strategies obviously with a greater weight in those areas that appear to offer the greatest opportunity. The resultant strategy is deep in the sense that in it goes into several areas of equity derivative risk as opposed to wide e.g. trading only volatility across multiple asset classes. This allows the team to specialise in the area of equity derivative risks and not a single risk e.g. volatility.

It is the team’s belief, based on many years of experience, that this multi-strategy approach, combined with a robust risk methodology, results in repeatable returns whilst not exposing the investor to the risk of a significant drawdown…a strategy that is genuinely alternative.

**Stephen Crewe** is the Lead Fund Manager of the F&C Sapphire hedge fund and has been running equity derivative based mandates since 1993.

**Christopher Childs** has worked at F&C since 1993 and joined Stephen Crewe in 1995 to form the F&C Derivatives Team. He has been the lead manager for the award winningHVB Stiftungsfonds since its inception in 2001 and runs Team Sapphire with Stephen Crewe.

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## Commentary

## Issue 134

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## Erik Norland, Senior Economist and Executive Director, CME Group