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Efficient VA Hedging Instruments for Target Volatility Portfolios
Jon Spiegel
Deutsche Bank
Equity Structuring | Global Investment Solutions | Global Markets
Efficient VA Hedging Instruments For Target Volatility Portfolios Jon Spiegel, Director | 212-250-6054 EBIG Conference - Chicago November 14, 2016 - 13:30 to 15:00 hours
For Institutional Investors Only – Not for Retail Distribution
Global Markets Deutsche Bank
Disclaimer (1/2)
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This presentation is provided for informational purposes only and does not create any legally binding obligations on Deutsche Bank Securities Inc. and/or its affiliates and Deutsche Bank Securities Limited (collectively “DB”). Without limitation, provision of this presentation does not constitute an offer, an invitation to offer, or a recommendation to enter into any transaction or to take any action on your part. The presentation does not constitute investment advice and DB is not acting in a fiduciary capacity with respect to you or any other party. Before entering into any transaction or making any investment decision you should take steps to ensure that you fully understand appropriateness of the action in the light of your own objectives and circumstances. You should consider seeking advice from your own advisers in making this or any other assessment, including professional tax, legal, accounting and other advisors. If after making your own assessment ywou independently decide you would like to pursue a specific transaction with DB there will be separate offering or other legal documentation the terms of which will (if agreed) supersede any indicative and summary terms contained in this document.
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The presentation is based on material DB believes to be reliable; however, DB does not represent that the presentation is accurate, current, complete, or error free. Any assumptions, estimates and opinions contained in the presentation constitute DB’s judgment as of the date of the material and are subject to change without notice. DB reserves the right, at any time and without notice, to discontinue making the presentation available. The presentation may not be reproduced or distributed, in whole or in part, without the DB’s express prior written approval. Any quantitative models, processes and parameters are subject to amendment, modification, adjustment and correction at DB’s discretion, and may incorporate DB’s qualitative judgment. DB will from time-to-time run or update any such models at its sole discretion.
The past performance of any securities, indexes or other instruments referred to herein does not guarantee or predict future performance. Please note that any market values provided may be affected by a number of factors including index values, interest rates, volatility, time to maturity, dividend yields and issuer credit ratings. Any calculations of returns on instruments referred to herein may be linked to a referenced index or interest rate. In such cases, the investments may not be suitable for persons unfamiliar with such index or interest rate, or unwilling or unable to bear the risks associated with the transaction. Any products denominated in a currency, other than the investor’s home currency, will be subject to changes in exchange rates, which may have an adverse effect on the value, price or income return of the products. These products may not be readily realizable investments and / or not traded on any regulated market. Any securities referred to herein involve risk, which may include interest rate, index, currency, credit, political, liquidity, time value, commodity and market risk and is not suitable for all investors.
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Disclaimer (2/2)
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This communication was prepared solely in connection with the provision of information related to the transaction or matter addressed herein, and was not intended or written to be used, and cannot be used or relied upon, by any taxpayer for purposes of avoiding any U.S. federal income tax penalties. The recipient of this communication should seek advice from an independent tax advisor regarding any tax matters addressed herein based on its particular circumstances.
Any prices or terms contained in the presentation are indicative and represent an indication of the prices or terms at which DB might have paid or charged, as of the time and date specified. Any prices do not represent a firm bid or offer on the part of DB. Firm bid/offer prices can only be obtained on a real-time, expressly agreed upon, basis. Any indicative prices may differ substantially from a firm bid/offer. Any indicative prices do not necessarily reflect DB’s internal bookkeeping or theoretical data-based valuations. Certain factors which may not have been assessed for purposes of these indicative prices, including, notional amounts, spreads, underlying volatility, costs of carry or use of capital and profit, may substantially affect a stated indicative price. Any indicative prices obtained from the presentation may vary significantly from valuations available from other sources. Accordingly, under no circumstances should you use the presentation for purposes of valuing your own books and records. DB or its affiliates or persons associated with DB or such affiliates may maintain a long or short position in securities or other financial instruments referred to herein, or in related futures or options, purchase or sell, make a market in, or engage in any other transaction involving such securities or other financial instruments, and earn brokerage or other compensation.
Securities and investment banking activities in the United States are performed by Deutsche Bank Securities Inc., member NYSE, FINRA, NFA and SIPC, and its broker-dealer affiliates. These instruments are not insured by the Federal Deposit Insurance Corporation (FDIC) or any other U.S. governmental agency. Securities activities in Canada are performed by Deutsche Bank Securities Limited, a Member of the Canadian Investor Protection Fund. These instruments are not deposit liabilities of Deutsche Bank and are not insured by the Canada Deposit Insurance Corporation. The distribution of this document and availability of these products and services in certain jurisdictions may be restricted by law
DB HEREBY SPECIFICALLY DISCLAIMS ALL LIABILITY FOR DIRECT, INDIRECT, CONSEQUENTIAL OR OTHER LOSSES OR DAMAGES, INCLUDING, BUT NOT LIMITED TO, LOSS OF PROFITS, THAT MAY ARISE FROM ANY RELIANCE ON THE PRESENTATION, OR FOR THE RELIABILITY, ACCURACY, COMPLETENESS OR TIMELINESS THEREOF, OR FOR ANY DELAYS OR ERRORS IN THE TRANSMISSION OR DELIVERY OF THE PRESENTATION.
Global Markets Deutsche Bank
Efficient VA Hedging Instruments For Target Volatility Portfolios
Agenda
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1 • Target Volatility Risk Properties
2 • Target Volatility Puts vs. Vanillas
3 • Other Tactical Hedging Instruments
Global Markets Deutsche Bank
Target Volatility Risk Properties
Introduction
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(1) Source: DB Equity Derivatives Research
Over the past five years, the AUM of VA managed volatility funds has grown to over $200bn1
Target volatility strategies are likely to exhibit long-term volatilities close to their targets, neutralizing the vega exposure of VA guarantees
However instantaneous equity risk scenarios still show significant crash-risk. Hedge with vanillas?
Global Markets Deutsche Bank
Target Volatility Risk Properties
Example: S&P 500 Risk Control Indices
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Source: Bloomberg Finance L.P. and DB Structuring
0
50
100
150
200
250
300
SPXT10UT SPXT15UT SPXT
Global Markets Deutsche Bank
Target Volatility Risk Properties
Realized Volatility (1yr)
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Source: Bloomberg Finance L.P. and DB Structuring
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50% SPXT10UT SPXT15UT SPXT SPXT10UT-Avg SPXT15UT-Avg SPXT-Avg
Global Markets Deutsche Bank
Target Volatility Risk Properties
Realized Skew: Realized Volatility vs. Returns (Semi-annual, Dec ’99 – Jun ‘16)
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y = -0.02x + 0.15
y = -0.11x + 0.10
y = -0.51x + 0.19
0%
10%
20%
30%
40%
50%
60%
-30% -20% -10% 0% 10% 20% 30%
SPXT10UT
SPXT15UT
SPXT
Source: Bloomberg Finance L.P. and DB Structuring
6m Return
6m R
ealiz
ed V
ol
Global Markets Deutsche Bank
Target Volatility Risk Properties
Historical SPX Implied Volatility vs. Subsequent Realized (12/31/1999 – 5/10/2016)
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Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research
0%
10%
20%
30%
40%
50%
60%
70% SPX 6m ATM Implied Vol
SPX 6m 90% Implied Vol
Subsequent 6m Realized
Global Markets Deutsche Bank
-40%
-30%
-20%
-10%
0%
10%
20%
30% ATM Implied - Realized
90% Implied - Realized
Target Volatility Risk Properties
SPX 6m Implied vs. Subsequent Realized Spread (12/31/1999 – 5/10/2016)
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Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research
Strike Avg Since Dec ’99
Avg Since Jan ’09
90% 5.58% 8.07%
100% 1.80% 3.75%
Global Markets Deutsche Bank
Target Volatility Puts vs. Vanillas
Introduction
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Intuitively it should be more efficient to hedge liabilities linked to target volatility funds using puts on target volatility indices to avoid overpaying for implied volatility and skew
We compare the performance of hypothetical target volatility puts with the performance of comparable listed options
Caveats: (1) The target vol index is a systematic proxy for portfolios which generally contain discretionary funds with diverse mandates (2) Target volatility puts are not widely traded, so pricing is hypothetical
Global Markets Deutsche Bank
Target Volatility Puts vs. Vanillas
Comparable Instruments Methodology
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We compare the PL from buying puts on target volatility indices with the PL from buying comparable vanilla puts, for each trade date
Comparing target volatility puts with vanilla equity puts requires careful consideration as the vanilla equity put embedded in a TV put has changing notional and strike over the life of the trade
We adjust the vanilla strike and notional to have equivalent intrinsic value on trade date for all equity scenarios (“equal crash protection”)
Dynamic Adjustment: Compare TV put to scaled vanilla put adjusted using most recent TV Participation Static Adjustment: Compare TV put to scaled vanilla put using fixed long-term average TV Participation
Global Markets Deutsche Bank
Target Volatility Puts vs. Vanillas
Comparable Instruments Adjustment
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Target Volatility
Index Cash
Allocation
Strike (e.g. 95%) Notional Adjustment
Strike Adjustment
%ionParticipatTVNotionalTVNotionalVanilla
%
%1%100
ionParticipatTV
StrikeTVStrikeVanilla
Equity Allocation
(not to scale)
Global Markets Deutsche Bank
Target Volatility Puts vs. Vanillas
Back-test methodology for TV 10% 6m 95% Put, Dynamically Adjusted
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• For each trading day, locate SPX listed expiration closest to 6 months Select Listed Expiration
• For selected expiration, locate strike closest to participation-adjusted TV equivalent
• Example: 70% participation 1-.05/.7 = 92.85% Select Scaled Vanilla Strike
• Adjust TV tenor and strike slightly to correspond with listed option used for scaled vanilla Adjust TV Tenor and Strike
• 10% TV 6m 95% put BS: 12.51 vol, fwd = libor flat • 10% TV 12m 90% put BS: 12.51 vol, fwd = libor flat • Scaled Vanilla Listed mid-market
Price TV and Vanilla Puts
(1) Indicative and hypothetical
Global Markets Deutsche Bank
0%
2%
4%
6% Target Vol Price Target Vol Payoff
Target Volatility Puts vs. Vanillas SPXT10UT 6m 95%; Dynamic Adjustment
Average Price and Payoff by Trade Date Year
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Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research
0%
2%
4%
6% Scaled Vanilla Price Scaled Vanilla Payoff
Global Markets Deutsche Bank
Target Volatility Puts vs. Vanillas SPXT10UT 6m 95%; Dynamic Adjustment
PL by Trade Date (Jan ’00 – Oct ’161)
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(1) Assuming that options unexpired as of Nov 11, 2016 expire OTM Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research
-15%
-10%
-5%
0%
5%
10%
15%
Trade Date
Scaled Vanilla PL Target Vol PL TV - Scaled Vanilla
Global Markets Deutsche Bank
Target Volatility Puts vs. Vanillas SPXT10UT 6m 95%; Dynamic Adjustment
PL by Trade Date (Since 20091)
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(1) Assuming that options unexpired as of Nov 11, 2016 expire OTM Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
Trade Date
Scaled Vanilla PL Target Vol PL TV - Scaled Vanilla
Global Markets Deutsche Bank
Target Volatility Puts vs. Vanillas
Target Vol Behavior in Different Sell-Offs
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Source: Bloomberg Finance L.P. and DB Structuring
Source: DB Structuring, Bloomberg
0% 20% 40% 60% 80% 100%
0%
50%
100%
Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Participation (RHS) SPXT10UT SPXT
0% 20% 40% 60% 80% 100%
0%
50%
100%
Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09
Participation (RHS) SPXT10UT SPXT
Global Markets Deutsche Bank
-0.4%
0.7%
-0.8%
0.3% 0.9% 0.7% 0.7% 0.3%
-3.6%
0.0%
0.6% 1.0% 0.8% 0.7% 0.9% 0.8% 0.6%
-5%
0%
5%
TV - Scaled Vanilla PL
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
SPX Return SPXT10UT Return
Target Volatility Puts vs. Vanillas SPXT10UT 6m 95%; Dynamic Adjustment
Target Vol Put vs. Scaled Vanilla PL, Average by Trade Year
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Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research
Since 2000 0.25% (0.50% p.a.)
Since 2009 0.67% (1.34% p.a.)
Global Markets Deutsche Bank
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
SPX Return SPXT10UT Return
-0.3%
0.5%
-0.5%
0.5% 1.5% 1.2% 1.1%
-0.8% -3.8%
0.1% 1.1% 1.0% 1.6% 1.5% 1.7% 1.0%
-5%
0%
5%
TV - Scaled Vanilla PL
Target Volatility Puts vs. Vanillas SPXT10UT 12m 90%; Dynamic Adjustment
Target Vol Put vs. Scaled Vanilla PL, Average by Trade Year
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Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research
Since 2000 0.47% p.a.
Since 2009 1.15% p.a.
Global Markets Deutsche Bank
Target Volatility Puts vs. Vanillas
Comparable Instruments Methodology
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Source: Bloomberg Finance L.P. and DB Structuring
We assume that the liability’s equity exposure matches the proxy index. But comparing to the vanilla, does a daily dynamic participation adjustment fairly capture equal crash risk?
Hedging with vanillas, as participation increases (decreases) would need to buy (sell) puts to hedge crash risk of target vol liability. IE, buy when vol is falling, sell when vol is rising
In another comparison we adjust each vanilla put strike and notional using the same long-term participation of 67%
0% 20% 40% 60% 80%
100% 120% 140% 160%
SPXT10UT Participation Average = 67%
Global Markets Deutsche Bank
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
SPX Return SPXT10UT Return
-0.7% -0.1% -0.4%
0.8% 0.2%
-0.1% -0.1% -0.3%
-5.3%
2.4% 1.3% 2.1% 0.7%
0.0% -0.1%
1.1% 0.4%
-10.0%
-5.0%
0.0%
5.0%
TV - Scaled Vanilla PL
Target Volatility Puts vs. Vanillas Back-tested PL Comparison – 6m 95% Static (67% Participation)
Target Vol Put vs. Scaled Vanilla PL, Average by Trade Year
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Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research
Since 2000 0.14% (0.28% p.a.)
Since 2010 1.0% (2.0% p.a.)
Global Markets Deutsche Bank
Target Volatility Puts vs. Vanillas
Dynamic vs. Static Hedging with Vanillas
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Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research
0%
20%
40%
60%
80%
100%
120%
-6%
-4%
-2%
0%
2%
4%
6%
8% Participation (RHS) Scaled Vanilla PL, Dynamic Scaled Vanilla PL, Static
Dynamic buys more, puts expire OTM
Dynamic buys less, puts expire ITM
Dynamic buys less, puts expire OTM
Global Markets Deutsche Bank
Other Tactical Hedging Instruments
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• Finance tail risk protection by selling ATM gamma 1x2 Put Spread
• Monetize skew to buy cheap vega, plus 1-day gap protection
Conditional Up-Variance Swap
• Monetize vol and skew with limited risk Variance KO Put
Global Markets Deutsche Bank
Delta-Hedged 1x2 Put Spread
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Using vanilla options, VA hedgers can set up a position that provides:
• Positive carry • Long skew, Long convexity, Deep tail risk protection
The strategy entails:
• Selling an ATM or near-ATM put • Buying 2 OTM puts • Delta hedging
In return for the above benefits, seller is exposed to high implied or realized volatility without a significant selloff in spot
Applicability: Target vol liabilities may incur less daily delta hedging than traditional VA and would be better positioned to sell local gamma
Global Markets Deutsche Bank
Delta-Hedged 1x2 Put Spread SPX 6m, Delta-based strikes
Indicative PL Back-test: Sell $1/6 notional every month
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Source: Bloomberg Finance L.P. and DB Structuring
0
500
1,000
1,500
2,000
2,500
-2%
0%
2%
4%
6%
8%
10%
12%
14%
50d/5d 50d/10d SPX (RHS)
Global Markets Deutsche Bank
Delta-Hedged 1x2 Put Spread SPX 6m, Delta-based strikes
Strikes Back-test
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Source: Bloomberg Finance L.P. and DB Structuring
0
500
1000
1500
2000
2500 SPX 50d Avg Strike 5d Avg Strike 10d Avg Strike
Global Markets Deutsche Bank
Delta-Hedged 1x2 Put Spread SPX 6m, Delta-based strikes
Gamma Back-test
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Source: Bloomberg Finance L.P. and DB Structuring
0
500
1,000
1,500
2,000
2,500
-1.0%
-0.8%
-0.6%
-0.4%
-0.2%
0.0%
0.2%
0.4%
0.6%
50d/5d 50d/10d SPX (RHS)
Global Markets Deutsche Bank
Delta-Hedged 1x2 Put Spread SPX 6m, Delta-based strikes
Vega Back-test
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Source: Bloomberg Finance L.P. and DB Structuring
0
500
1,000
1,500
2,000
2,500
-0.20% -0.15% -0.10% -0.05% 0.00% 0.05% 0.10% 0.15% 0.20% 0.25%
50d/5d 50d/10d SPX (RHS)
Global Markets Deutsche Bank
ind(Pt-1) equals 0 if spot at t – 1 is above barrier, otherwise equal to 1
N is expected number of trading days from Trade to Expiration
“Conditional Up-Variance Swaps” only accrue variance if the spot price is above a barrier.
Applicability: Use ITM (downside) barrier; Provide 1-day gap protection as barrier is observed t-1; Best for portfolios requiring some long vega exposure
Conditional Up-Variance Swap
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Nt
t
Nt
t
ind
ind
11t
11t
2
1-t
t
)P(
)P(P
Pln252
zedUpVarReali
zed)UpVarReali- ke(UpVarStriatioOccurenceRNotionalPayoff
N
ind
Nt
t
1
1t )P(
atioOccurenceR
Global Markets Deutsche Bank
Conditional Up-Variance Swap
Given steep skew, up-variance strikes are lower than regular variance
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(1) Hypothetical back-test
Source: DB Structuring
76% 78% 80% 82% 84% 86% 88% 90% 92% 94%
0%
10%
20%
30%
40%
50%
60%
70%
Indicative SPX 6m Up-Var Strike Indicative SPX 6m Var Strike Barrier = 25% delta put strike (RHS)
Average Spread = 3.81
Trade Date
Global Markets Deutsche Bank
Conditional Up-Variance Swap
Realized Conditional Variance and Occurrence Ratio
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Source: Bloomberg Finance, LP and DB Structuring
0%
20%
40%
60%
80%
100%
120%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90%
Realized 6m Var
Realized 6m Up-Var
Occurrence Ratio (RHS)
Trade Date
Global Markets Deutsche Bank
Conditional Up-Variance Swap
Except for Trades done in 2008, Up-Var generally would have outperformed regular Var
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(1) Hypothetical back-test
Source: Bloomberg Finance, LP and DB Structuring
Trade Date
-20% -10%
0% 10% 20% 30% 40% 50% 60% 70%
6m Var PL 6m Up-Var PL (Equal Var Notional)
Average Spread = .441 vols Since 2009 = 2.951 vols
Global Markets Deutsche Bank
0.00
0.20
0.40
0.60
0.80
1.00
1.20
40% 60% 80% 100% 120% 140% 160% 180%
Regular Var Vega Upvar Vega
Conditional Up-Variance Swap
Vega scenarios (6m, 92% barrier)
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Source: Bloomberg Finance, LP and DB Structuring
Spot % of Initial
Global Markets Deutsche Bank
A Variance Knock-Out Put pays zero if the realized variance surpasses a “budget” during the life of the trade. Otherwise it pays the same as a vanilla.
Applicability: Typically traded by hedge funds. Structure is short-vega and skew, with limited liability. Target volatility hedgers may be positioned to sell vega and skew opportunistically
Variance Knock-Out Put
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Example: Underlying: SPX Tenor: 6m Strike: ATM Spot Variance Budget: (Implied Variance)^2 * 0.5 Implied Variance: 0.19 Indicative Cost: 1.3% (72% discount to Vanilla) Vanilla 6m ATM Put: 4.6%
2t
1i 1i
i
S
SlntVariance Realized
PX
PX
Global Markets Deutsche Bank
Variance Knock-Out Put
Implied skew and convexity premia cause the VKO to price the survival rate lower than statistically observed
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(1) Hypothetically back-tested
Source: Bloomberg Finance L.P and DB Structuring
Most negative SPX Returns Avg SPX Return Survival Rate
Avg VKO Px/ Vanilla Px1
0% to 5% -36.27% 0.0% 28.5%
5% to 10% -15.89% 22.9% 28.4%
10% to 15% -7.89% 54.3% 28.4%
15% to 20% -4.42% 65.7% 28.8%
20% to 25% -2.35% 46.2% 29.1%
25% to 30% -0.19% 81.9% 29.5%
30% to 35% 1.78% 89.5% 35.9%
35% to 40% 2.93% 94.3% 33.2%
Quantile Analysis: SPX 6m ATM VKO; barrier = 6m SPX implied variance on trade date Trade Dates Jan ’08 to Apr ‘16
Global Markets Deutsche Bank
Variance Knock-Out Put
Vega Evolution: SPX 6m ATM VKO (19.4% budget) Back-Tested from 10/30/2015
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Source: Bloomberg Finance L.P and DB Structuring
1650 1700 1750 1800 1850 1900 1950 2000 2050 2100 2150
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16
VKO Price
SPX (Right)
15%
17%
19%
21%
23%
-0.6%
-0.5%
-0.4%
-0.3%
-0.2%
-0.1%
0.0%
0.1%
0.2%
Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16
VKO Vega Vol MTM of Varswap (Right)
Global Markets Deutsche Bank
Final Thoughts
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Target volatility strategies exhibit less skew as well as more predictable volatility than pure equity. Hedging strategies should benefit from both of these characteristics.
Buying puts on TV Indices may provide crash protection with less risk premium cost.
“Light Exotics” such as Conditional Variance and VKO’s can monetize expensive skew.
Ongoing work: -- Assessing tracking error of VA Portfolios vs. TV Indices. Designing custom
benchmarks where appropriate -- Price discovery for Target Volatility Puts -- Portfolio diversification from trading combinations of these instruments