Any end-users looking to use a derivative instrument should first satisfy themselves of two main points:
q Does the market have enough depth of liquidity to allow efficient entry and exit of positions?
q Is the user comfortable in taking on counterparty risk?
As standardised products, exchange listed derivatives offer the deepest pool of liquidity without the worry of a single name risk. Hence their continued popularity.
The wealth of products on offer in exchange traded form means that strategies can be created to suit almost all forms of risk exposure.
Here are some of the most common exchange traded strategies used by end-users in the marketplace today.
Case Study: Limiting exposure to guaranteed
The steep fall in long-term interest rates over the past couple of years has caused problems for many pension funds that have issued guarantees.
Put simply: once the yield level goes below a certain point then the fund finds itself exposed to the yield difference. How do you hedge this exposure?
One way would be to enter in to a futures position in a related instrument such as the Bund contract. The problem with this method is the directional risk, ie, should Bund prices fall then the hedge now becomes its own liability. A less rigid method would be to use an options strategy.
For example, a fund manager needs a strategy that would cover his liabilities should 10-year yields fall below 3.25%. Solution – purchase a Bund option call at the strike that matches a 3.25% yield as closely as possible. In this case the 122.00 strike. Based on data from 27 October a January call option (expiry 22 December) would cost 38 ticks. The profile of this position on expiry would be as shown in example 1:
This is the simplest method using options as it guarantees limitless upside exposure. However, a fund manager may take a slightly more pragmatic approach and decide that it is unlikely that yields would go below 3%. In this case, he can reduce his initial outlay by simultaneously selling the 124.00 strike for six ticks. (3% yield equivalent). Cost for the call-spread package is 32 ticks (this represents 0.32% of fund value). Payout as shown in example 2.
Although the payout is now capped, the position still fits in with the overall view of the fund manager, but at a reduced cost.
With both these options trades, maximum loss is just the initial premium paid; whereas a futures position would give an unwanted one-for-one market exposure should the market trade downwards.
An Active Approach
Once comfortable with the basics of using derivatives to hedge a cash portfolio, the next stage is to consider a dynamic approach. ‘Active overlay’ is an umbrella term describing the trading of derivative products around a core position of cash securities. The approach is a logical extension of traditional downside hedging and covered call writing programmes. However, it implies a broader mandate.
Rather than being restricted to only buying protection, or only writing options for a certain return level, the active overlay manager trades around the core cash security positions and is also able to trade volatility in addition to straight directional plays.
The active overlay has several component strategies that can be employed singly or in combination:
q Risk Management;
q Active Asset Allocation;
q Market Timing Strategies;
q Yield Enhancement;
q Special Situations;
q Volatility as an Asset Class.
We will look at each of these in turn before discussing the practicalities of implementing such an approach.
As the case study in the first part of this article highlights, one of the core uses of option overlays remains protection strategies. The example outlines basic risk assessment and mitigation considerations, however, volatility plays a major role and there are two important factors to consider:
q Structuring the Position:
Volatility analysis allows end users to ascertain whether certain options strikes are cheap/expensive in relation to others and also whether skew presents opportunities for selling more expensive strikes in volatility terms when trading put spreads, eg, in a high skew environment users may choose to buy Put Spreads rather than Puts as they are able to buy the low volatility Put while selling a higher volatility Put;
q Managing the Position:
There are a whole host of factors to consider such as rolling the strikes upwards should the market move up through a certain level, and deciding if and when to roll the position forward into a later expiry month to extend the hedge.
Active Asset Allocation
Traditional approaches to long-only asset management centre on a static approach to asset allocation decisions: place your cash market bets and then stick with them. A more progressive and dynamic approach is to use derivatives to rebalance holdings as market conditions change. During 2005 we saw increased interest in Japanese equities. Rather than immediately sell out of US or European equity holdings to buy Japan, it was possible to take a position first using options or futures and then rebalance cash holdings thereafter. This is an efficient and expeditious method of gaining the desired market exposure.
Market Timing Strategies
A manager may hold a short-term view that differs from his core position and it is often more efficient to trade with an overlay than moving a cash position. For example, historically as we approach year-end, if YTD performance in the cash markets has been positive then there is an 80% probability that Nov/Dec returns will also be positive. A portfolio manager who believes in the rally, but holds a longer-term bearish stance is likely to be underweight equities. In this case buying a short-dated call spread is a smart way of gaining limited risk exposure to the rally while leaving the long-term view and position unchanged.
Overwriting for yield enhancement remains a key strategy for generating positive carry. The change in approach is that rather than looking at the yield in terms of premium, managers are now thinking in terms of volatility levels.
Opportunities arise throughout the year based around company specific, economic or political events. In October 2005 the German elections created a kink in the volatility surface as many users looked to cover against a sharp post-election move in the equity markets. From a hedging perspective, those aware of the high demand for October DAX implied volatility were able to trade serial months or a related market. From a volatility arbitrage perspective, this created opportunities to sell the over-bought part of the curve and hedge with related markets.
Volatility as an Asset Class
There has been increasing focus on volatility as a separate asset class over the past 12 months. The emergence of products such as variance swaps and reference indices such as VIX/VSTOXX futures has driven this forward.
Within the fund management community, research has shown that long biased funds are systemically long volatility.
Consequently, active managers tend to hold long volatility positions to cover this. It is also possible to trade volatility for Alpha; volatility exhibits strong seasonal and mean reverting properties and opportunities arise all through the year.
One of the key elements to making good, well-informed decisions is the data used. This includes; quantitative information, predictive information and trade ideas.
Mako is a leading provider of liquidity in Equity, Fixed Income and Money Market Options and invests heavily in Financial Engineering. Consequently, Mako has excellent volatility information and powerful tools for analysing the volatility surface.
Output includes Daily Overviews, Weekly Summaries, Bespoke Analysis and Trade Ideas.