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[M4U]

Acho que foi o Jesse Livermore que disse:


"There's a time to go long, a time to go short and a time to go fishing..."

[LTCM]

Bank of America Merrill Lynch offers tradable volatility index for tail risk hedging

Author: Clare Dickinson, Structured Products

Source: Hedge Funds Review | 28 Jul 2010

Categories: Investors

Topics: Stochastic volatility, implied volatility, Standard & Poor's, Risk, Bank of America Merrill Lynch (BAML), index, Structured products

Bank of America Merrill Lynch (BAML) has developed a liquid volatility index for institutions seeking a systematic tail risk hedge and aimed meeting institutional demand in the US.

"During the credit crisis we started to see an overwhelming need from our investor group for tail risk hedges," says Yuriko Mita, co-head of derivatives sales at BAML in New York.

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BAML came up with the index which uses options on the benchmark S&P 500 index with five-month maturities rolled on a daily basis. The index gives 1.2 times the return of those contracts.

Tail risk is the risk of an asset or portfolio moving more than three standard deviations from its current price.

"A lot of the flow we have been seeing in the equity markets at the moment is about systematic tail risk hedges. Investors put them on and keep them on for years," says Mita.

"The existing product suite most investors look to is too expensive. The carry investors have to pay to keep the trades on would eat into their returns. The team started to tinker and develop a hedge that had decent sensitivity to moves down in the market with the least amount of decay," Mita adds.

The benchmark volatility index is the Vix Index, calculated by the Chicago Board Options Exchange (CBOE). This index is not tradable and other volatility products have produced other problems, according to BAML.

Last year Standard & Poor's (S&P) created the S&P 500 Vix Futures Index Series, one of the indexes that served as the underlying to the most successful ETN in the US market in 2009. This is a costly way of investing in volatility, according to Yoni Epelbaum, managing director in global equity linked products at BAML in New York.

"The S&P 500 Vix Short-Term Futures Index trades forward volatility. If you trade volatility in a one to two-month range it costs you a lot because the front part of the forward volatility curve is very steep," he says.

"Rolling shorter-term Vix futures is expensive. In a quiet market environment, you can lose 10% of your value every month through decay. The idea with our index is that if you go further down the curve it's flatter, so you don't lose nearly as much over time," continues Epelbaum.

"The problem can then be that the level of volatility at the longer maturities is less responsive to market moves. What we did with our index was to take this optimal area where you don't get a lot of decay and we added a 1.2 multiplier to get a bigger return," he adds.

The Vix Index calculates implied volatility. The spread between implied volatility and realised volatility is wide, with realised volatility being lower. Because investing in the asset class is usually done by investing into implied volatility, investors normally end up losing money because they are paying for implied volatility but getting the returns of realised volatility.

BAML's index looks at implied volatility further forward than other volatility measures, getting rid of exposure to the implied-realised spread. By using five-month contracts, it maintains the liquidity near-term contracts provide.

"There have been other products that have aimed to give access to volatility but the benefits of diversification versus the cost of holding the product have meant the product wasn't very efficient," says Epelbaum.

"We designed the index to optimise the efficiency between the benefits you get when the market goes down versus the cost of holding the product when the market is quiet."

Hedge funds, funds of funds and investment management companies are all looking for a systematic, low-cost tail risk hedge, according to Mita.

The BAML index can be traded via over-the-counter swaps or index-linked notes. The bank is also looking to develop a retail product on the index.

The index is calculated by the CBOE.

[Pata-Hari]

Amén.

[LTCM]

On the price of insurance and the bull market in tail risk
From the people who bought you such wonderful ideas as CDOs, now comes the bull market in tail risk products. Deutsche are launching a long equity volatilty index, Citi has come up with a crisis index (mixing equity and bond vols, swap spreads and structured credit spreads). Bloomberg reports that PIMCO is planning a fund that will protect investors in the event of a decline greater than 15%. The CBOE is planning a new index based on the skew in the S&P500.

In the past I've talked about the need for cheap insurance, and the benefits that this can bring to a portfolio in terms of robustness. However, the key word is that the insurance must be cheap (or at very worst fair value). Buying expensive insurance is a waste of time. I used to live in Tokyo and was constantly amazed that the day after an earth tremor the cost of earthquake insurance would soar, as would the demand! You should really only want insurance when it is cheap, as this is the time when the no one else wants it, and (perversely) the events are most likely.

Buying expensive insurance is just like buying any other overpriced asset...a path to the permanent impairment of captial. Rather than wasting money on expensive insurance, holding a larger cash balance makes sense. It preserves the dry powder for times when you want to deploy capital, and limits the downside.

So buy insurance when it's cheap. When it isn't and you are worried about the downside, hold cash. As Buffet said holding cash is painful, but not as painful as doing something stupid!

by James Montier