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Index variance swaps trigger stock market volatility

Strategists say variance swaps causing volatility

Options strategists say increased activity in variance swaps is pushing up volatility in the final half hour of share trading sessions in the U.S. "The U.S. market volatility in the last 30 minutes to an hour might be explained by people hedging their variance swap positions because it is a function of the closing price, so traders will hedge as near to the closing price as possible," said Nicolas Mougeot, head of options strategy at Deutsche Bank. "With an option you can hedge during the day because it is a continuous position." Financial News Online

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Index variance swaps trigger rise in volatility
 
Renée Schultes
 
10 Sep 2007
Volatility has been rising sharply in the final 30 minutes of US share trading sessions, which options strategists attribute to high activity in hedging derivatives contracts known as variance swaps.

 The pattern of the swaps, which provide exposure to the variability of an underlying market or stock, has emerged in the past two weeks and is most visible on the benchmark S&P 500 index.

Last Tuesday the Vix index, a measure of the S&P 500’s volatility, rose by 5% 30 minutes before the close, which led to a 0.5% decline in the index.

Volatility on the Eurostoxx 50 index showed a similar phenomenon in May last year, when stock markets fell sharply because of the rising inflation threat.

Nicolas Mougeot, head of options strategy at Deutsche Bank, said: “The US market volatility in the last 30 minutes to an hour might be explained by people hedging their variance swap positions because it is a function of the closing price, so traders will hedge as near to the closing price as possible.

"With an option you can hedge during the day because it is a continuous position.”

A head of equity derivative flow sales at a US investment bank said: “As long as you have an equilibrium of buyers and sellers, there should be no effect on the index level. It is only at points of stress where it might have an impact on the market.”

Mougeot said longer dated volatility, which is a measure of how volatile traders and investors believe markets will be in future, rose sharply before the summer.

He said: “That could be because the markets are expecting equities to be more volatile, which was not the case in February and March this year when long-dated volatility barely moved. Or it could be because of the lack of a natural sellers.

"On the one hand you have a supply of long-dated volatility through structured products and you have natural sellers, which are hedge funds, selling index volatility through dispersion trades. Many hedge funds might have held off doing that.”

A typical dispersion trade sees an investor take a short position on the volatility of the index and long positions on individual stocks.

The Vix index has risen 106% since the beginning of June. Last Friday it was trading at about 26.

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