Ansbacher Investment Management Inc., New York, is preparing to launch a new hedging strategy to help institutional investors take advantage of overpricing of equity index volatility.
The firm designed its equity index variance swap strategy as a way to gain exposure to the high volatility premium, which reflects the fact that investors are willing to overpay for the put options they buy to hedge their stock positions. Variance measures the magnitude of the random departure found in volatility, the deviation from the usual return on a financial investment. Variance swaps are over-the-counter derivatives contracts, based on the difference between implied or expected and realized or actual volatility.
Buying put options comes at a hefty premium because of the risk involved for the put seller if the stock market experiences large, sudden drops as has often been the case since early 2007.
On Feb. 26, 2007, the market looked pretty calm. The next day, the Dow (Jones industrial average) lost 416 points and the (volatility) VIX index almost doubled. Such unexpected swings explain why people pay so much for put options so that they can sleep at night, said Jason Ungar, a director at Ansbacher, referring to the Dow's biggest one-day drop in six years.
The new strategy combines short one-month variance swaps and long three-month forward swaps to capture the spread between implied and realized volatility while getting protected at the same time against a volatility spike.
Our variance swap strategy allows investors to capture this rich source of alpha while simultaneously hedging the "tail risk' inherent in being short volatility, Mr. Ungar said. Isabelle Clary