Volatility Derivatives are one of the post-crisis survivors of financial products. As part of the ISDA Definitions the June 2013 Volatility Swap and Variance Swap Supplement to the 1998 ISDA FX and Currency Option Definitions has replaced the May 2011 version. After the set of barrier and touch products, for which a similar supplement is in place since 2005, the variance and volatility swaps were the next to be standardized in the FX derivatives market. Calculation of historic variance and volatility should now finally be considered standard market practice. I am surprised that among all kind of exotic options and structured products, it is the variance and volatility swaps that are considered standard derivatives. Why did that happen? Why didn’t ISDA standardize flip-flop swaps and Himalaya options? One of the reasons could be that hedging uncertainty has become more important after 2008, and volatility derivates are one way of going about it. For example, we have analyzed and reported about how one can hedge crash risk in an asset management context using a calendar spread of variance swaps for stock indices. As a fan of formula-based payoffs in derivatives transactions, I am pleased to observe that the lawyers have finally given up trying to convert a payoff formula into 20 pages of incomprehensible text just because of an alleged market consensus that mathematics is only for nerds. Besides variance and volatility swaps, forward volatility agreements are also popular FX derivatives. A typical version of such an agreement is a forward-start straddle, a call and put with the same (ATM) strike, where the ATM strike will be set at a future date based on a volatility fixed at inception of the transaction. The calculation of the ATM strike follows standard market practice in FX as described in our paper on FX Options quoting conventions. The premium for the forward-start straddle can be on the spot date corresponding to the fixing date of the volatility, which implies that there is no cash-flow at inception, but a transaction that feels like a swap on the strike fixing date. Several pricing platforms support such products already. The cost of poor volatility modeling can be substantial and can ruin a business as we have seen in the past. Among others an analysis of this was presented at the 2008 SIAM conference on financial engineering, which showed that the choice of a pricing and risk management model for the volatility is crucial to determining the hedging costs. A wide bandwidth of model prices underlined how risky it can be to take large positions in forward-volatility-sensitive products even if models are sophisticated. One of the big hurdles was the lack of a liquid forward volatility market. Let us see if all the increased standardization of volatility derivatives can really help tune down the risk in financial markets. List of references: More in ISDA FX can be found here One of the most read papers on variance swaps is the one called “More Than You Ever Wanted to Know About Volatility Swaps” A Guide to FX Options Quoting Conventions by Uwe Wystup and Dimitri Reiswich in The Journal of Derivatives ,Winter 2010, Vol. 18, No. 2: pp. 58-68. Volatility as an investment On the Cost of Poor Volatility Modeling: The Case of Cliquets, by Fiodar Kilin, Morten Nalholm and Uwe Wystup, Research Report, Center for Practical Quantitative Finance, Frankfurt School of Finance & Management. February 2008. Uwe Wystup Managing Director of MathFinance
Posted on: Tue, 15 Oct 2013 08:57:24 +0000
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