R&D /61

Volatility arbitrage
indices – a primer

Keith Loggie, director global research & design

at Standard & Poor’s Index Services, looks at the
­instruments and their context

I
n broad terms, volatility arbitrage This strategy is often implemented
can be used to describe trading through a delta-neutral portfolio consist-
strategies based on the difference in ing of an option and its underlying asset.
volatility between related assets – for The return on such a portfolio will be
instance, the implied volatility of two based not on the future returns of the
options based on the same underly- underlying asset, but rather on the
ing asset. However, the term is most volatility of its future price movements.
commonly used to describe strategies Buying an option and selling the
that take advantage of the difference underlying asset results in a long
between the forecasted future volatility volatility position, while selling an option
of an asset and the implied volatility of and buying the underlying asset results
options based on that asset. For more in a short volatility position. A long
detail on volatility see ‘box’ on page 67. volatility position will be profitable to the

Payoff
Implied Realised
Volatility – Volatility = of Volatility
Arbitrage

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/62 R&D R&D /63

extent that the realised volatility on the A long variance swap position will
underlying is ultimately higher than the
Implied Variance
profit if the realised variance of the
" The variance swap market has grown
implied volatility on the option at the time
Variance Variance underlying asset is greater than the ­exponentially over the past decade and is
of the trade. implied variance at the time the swap is
While delta-neutral options-based swap buyer swap seller struck. A variance swap provides pure among the most liquid equity derivatives
trades provide a means for investing
based on a view of future volatility, they Realised Variance
exposure to volatility, as, unlike options
prices, its value is based solely on
contracts in the over-the-counter markets."
do present some drawbacks. Since the changes to volatility.
delta of an option changes as the price The payoff of a variance swap is equal
of the underlying asset changes over feasible for traders as they cannot the other leg, the strike, is set at the to the difference between realised
time, a portfolio consisting of an option constantly alter their hedge. Thus the ­inception of the swap and is based variance and implied variance, multiplied
and its underlying asset that is initially position will generally not be solely on the squared amount of the implied by the number of contract units. The
delta-neutral will soon no longer be so. dependent on volatility and is therefore ­volatility of the underlying asset at the number of contract units is set such that
At this point, the performance of the not an ideal means of trading volatility. time the swap is struck. if the realised volatility is one volatility
portfolio is no longer based solely on The strike price of the swap is point above the strike, the payoff to the
volatility of the underlying asset but also Variance swaps determined by the implied volatility of the receiver of realised volatility will be equal
on the performance of the underlying An alternative to options-based ­volatility options currently traded in the market to the notional value of the contract.
asset. This can be prevented by trading is to use variance swaps. In based on the underlying asset. Thus a The variance swap market has grown
­continuous delta hedging, or ­rebalancing a variance swap, one leg is valued variance swap position is equivalent to a exponentially over the past decade and
of the portfolio to ensure that it is delta based on the realised variance ­(volatility portfolio of options on the underlying is among the most liquid equity deriva- such as variance swaps will tend to be against the actual realised volatility for
neutral. However, this not only creates squared) of the underlying asset, as asset and can be hedged in such tives contracts in the over-the-counter priced at a higher implied volatility than the following one-month period. The
transaction costs, but also it is not measured by logarithmic returns, while a manner. markets. While the most liquid underly- is actually expected to be realised. start and end dates of each monthly
ing index is the S&P 500, there are also Based on the above discussion, period are determined by the expiration
markets in EuroStoxx 50, FTSE 100 and writers of options and investors who take date of VIX options, generally the third
Exhibit 1: Implied and Realised Volatility of S&P 500 Nikkei 225 contracts as well. a short volatility position in a variance Friday of each month. One can see that
An interesting characteristic of swap or similar product should profit in general the implied volatility is higher
volatility is that for most traded assets, over time. Historical data bears this out. than the realised volatility.
implied volatility tends to be higher than As noted above, the most popular The trend for implied volatility to be
actual realised volatility. This is due to underlying index for variance swaps is higher than realised volatility is quite
% the fact that options are often used as a the S&P 500 and the implied volatility of consistent. Exhibit 2 shows that implied
35 hedge or insurance. An investor will the S&P 500 is measured by VIX, the volatility exceeds realised volatility in 86
purchase a put option to hedge against CBOE Volatility Index. VIX measures the per cent of the months. Furthermore,
large downward price movements or a implied volatility of the S&P 500 based the average and median differences
30
call option to hedge against large on the entire strip of S&P 500 options where implied exceeds realised is more
upward price movements. contracts and uses the near-term and than the months where realised
25
The options market is in many ways next-term options to calculate the exceeds implied.
similar to the home insurance market. implied volatility of the S&P 500 over the
Investors using options buy protection next 30 calendar days. Indexation of volatility arbitrage
20 from changes in prices, much as a Exhibit 1 tracks the implied volatility of Over the past year, transparent
homeowner purchases insurance the S&P 500 as measured by VIX ­indexation of volatility arbitrage has been
against fire, flood damage, etc. In both
15 cases, the provider of the insurance is
paid a premium to compensate for the
risk that is being taken.
10
Just as insurance companies price Exhibit 2: One-Month Implied versus Realised Volatility
their policies so that they expect to
Implied Exceeds Realised Exceeds
5
make a profit based on estimates of their Realised Implied
Feb Feb Feb Feb Feb Feb Feb Feb Feb Feb Feb Feb Feb Feb Feb Feb Feb Feb Feb eventual payouts, options writers will
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 Number (%) of Observations 190 (86.36%) 30 (13.64%)
only be willing to write options if they can
Implied Volatility Realised Volatility expect a sufficient profit to compensate Average Monthly Difference 5.34% 3.63%
for the risks they are assuming. Thus, Median Monthly Difference 5.00% 3.13%
Source: Standard & Poor’s, CBOE. options and options-based structures Source: Standard & Poor’s. Data from February 1990 to June 2008.

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" The choice of vega is an important VIX between 12.00pm and 1.00pm on
the roll date, less 1 per cent to account Index methodology
­determinant, and probably the principal for implementation slippage. The
performance of the index is calculated As noted in the main text, the S&P 500 Volatility Arbitrage where:
qualitative element in design of volatility based on the difference in the implied Index is rebalanced on the third Friday of each month. The
Indexi = The closing price of the S&P 500 on day i.
­arbitrage indices." variance less the realised variance of the
S&P 500 from the prior rebalancing date
methodology approximates a one-month variance swap
­position that receives implied variance on the S&P 500, as n = The number of trading days from, and including,
through the current date. measured by the VIX, the Chicago Board Option Exchange the prior rebalancing date, t-1, but excluding the
This difference is multiplied by the Volatility Index, and pays realised variance on the S&P 500. current rebalancing date, t.
variance notional, equal to vega The total return version of the index incorporates interest
(a volatility exposure modifier) divided accrual on the notional value of the index. Interest accrues VarianceNotionalt = * Vega (4)
introduced to serve as benchmarks for until the third Friday of the following by twice the strike price (which converts based on the one-month US dollar Libor rate.
volatility arbitrage strategies and to serve month, at which time the position is volatility points into dollar amounts). where:
as underlyings for index-linked products. rolled over. The index is calculated on a For more details see the ‘box’ on Index calculations
Vega = A limit to the exposure on the spread.
The S&P 500 Volatility Arbitrage Index price return (unfunded) and total return page 65. On any rebalancing date, t, the index is calculated as follows:
30 per cent is used for this index.
measures the performance of a variance (funded) basis. The total return index The choice of vega is an important
IndexValuet = IndexValuet-1 * (1 + VolArbStrategyt ) (1)
swap strategy that consists of receiving includes interest accrual on the notional determinant, and probably the principal
Total Return Index
the implied variance of the S&P 500 value of the index based on the one- qualitative element in design of volatility where:
A total return version of the index is calculated, which
and paying the realised variance of the month US dollar Libor rate. arbitrage indices. As Exhibit 3 shows, the
IndexValuet-1 = The index value as of the last includes interest accrual on the notional value of the index
S&P 500. The implied variance used for the higher the vega, the higher the expected
rebalancing date (t-1). based on the one-month US dollar Libor rate, as follows:
The index assumes a one-month index, equivalent to the strike price of a return and risk from the index. For the
variance swap is entered into on the corresponding variance swap, is S&P 500 Volatility Arbitrage index, the VolArbStrategyt = A percentage, as determined
TRIVt = TRIVt-1 * (1+LIBORt-1 * (dt-1,t /360) + VolArbStrategyt )
third Friday of a given month and is held measured based on the average level of vega is set at a level of 30 per cent. by the following formula:
where:
VolArbStrategyt = VarianceNotionalt-1 * [(IVSt-1 ) – (RVSt-1,t ) ] (2)
2 2
TRIVt = Total return index value as of the current
Exhibit 3: Impact of Vega on Volatility Arbitrage Index Returns
where: rebalancing date, t.

35% t-1 = The last rebalancing date TRIVt-1 = Total return index value as of the last
Return 34%
rebalancing date, t-1.
IVSt = Implied Volatility Strike. On any
Risk ­rebalancing date, t, it is represented by dt-1,t = Count of calendar days from the prior
30%
the equally-weighted average of the levels rebalancing date, t-1, to the current rebalancing
of VIX, the CBOE Volatility Index as date, t, but excluding the prior rebalancing date.
published by the CBOE, minus 1 per
25% LIBORt-1 = 1 month US dollar Libor rate as of the last
cent. The average is calculated using the
rebalancing date, t-1.
index levels as published by the CBOE
20%
every five minutes from, and including,
Base Date
12:00pm to, and including, 01:00pm (ET),
19% The index base date is February 16 1990 at a base value
divided by 100. For index history prior to
of 100.
15% January 18 2007, IVSt is represented by
15% the average of the high value and low
Index committee
13% value of VIX as published by the CBOE,
The S&P Arbitrage Index Committee maintains the S&P
10% divided by 100, minus 1 per cent.
500 Volatility Arbitrage Index. The Index Committee meets
regularly. At each meeting, the Index Committee reviews any
7% RVSt-1,t = Realised Volatility Strike of the S&P 500
7% significant market events. In addition, the Committee may
5% calculated using the following formula:
4%
revise index policy for timing of rebalancings or other matters.
Standard & Poor’s considers information about changes to
0%
2% its indices and related matters to be potentially market
10% 30% 50% 100% moving and material. Therefore, all Index Committee discus-
RVSt-1,t = (3)
Vega sions are confidential.

Source: Standard & Poor’s. Data from February 1990 to June 2008.

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/66 R&D R&D /67
Exhibit 4: Return and Risk Characteristics of S&P 500 Volatility Arbitrage Index Implied and realised volatility explained
S&P 500 Volatility Arbitrage S&P 500
Implied volatility different implied volatility than those options prices. An example of this is
Annualised Return Standard Deviation Annualised Return Standard Deviation Implied volatilities are derived from that expire in three months. This is the VIX calculation, a measure of
3 Year 8.26% 4.44% 4.69% 13.02% ­options prices. The implied volatil- referred to as the term structure of implied volatility of the S&P 500.
5 Year 10.31% 3.66% 7.75% 11.94% ity of an option is the level of volatility volatility. Also, options expiring at the
10 Year 11.49% 4.94% 3.49% 17.36% consistent with the current market same time but at different strike prices Realised volatility
Since Inception 12.72% 4.38% 9.21% 14.75% price of the option. Of the factors that tend to be priced based on different The realised volatility of an asset is the
Correlation with S&P 0.47 1.00 determine the value of an option, strike implied volatilities. This is due volatility of the actual historical ­returns
500 8 0 price, stock price, time to expiration, to what is known as the volatility skew. of an asset. Thus, unlike implied
volatility, expected cash flows and the Options pricing models such as ­volatility which is a forward-looking
Correlation with Lehman – 0.01
risk-free interest rate, volatility is the Black-Scholes make the simplifying prediction of volatility, realised volatility
Aggregate 0.029 3
only factor that is unknown. assumption that returns of the is backward looking. For example, one
Per cent of Month Positive 85.91% 61.36%
The value of an option is dependent ­underlying asset are normally could calculate the realised volatility of
Largest Drawdown 6.35% 41.71% on the future volatility of the underlying ­distributed. However, in reality this is the S&P 500 of June 2008 by ­taking
Source: Standard & Poor’s. Data from February 1990 to June 2008. asset. As future volatility is unknown, not generally the case. Stock returns, the standard deviation of the daily
the price of an option in the market will for example, tend to be long-tailed with returns of the index within that month.
be determined by investors’ expecta- more observations far from the mean For variance swaps, realised ­volatility
Exhibit 5: Performance of S&P Volatility Arbitrage since Inception tion of what the volatility of the asset than would be expected based on a is calculated based on logarithmic
will be. Thus, for a given options normal distribution. Since the chances returns rather than arithmetic returns.
1,200 pricing model such as Black-Scholes, of an extreme observation are more The difference between implied
the implied volatility of an option can likely than would be implied by a volatility and realised volatility is that
1,000
be inferred based on the current normal distribution, the implied volatility implied volatility is a forecast of the
market price of the option. of far in the money and far out of future realised volatility of an asset.
For a given underlying asset there the money options will tend to be While implied volatility is measured
800 will often be numerous options traded higher than that of at the based on the prices of options based
on it, based on different strike prices money options. on the underlying asset, realised
600
and expiration dates. These options Because of the skew in the term volatility is calculated based on actual
will generally not trade with the same structure of volatility there is not a historical returns of the underlying
implied volatility. For example, single direct measure of implied asset. Implied and realised volatility will
400 ­investors may expect a quite different volatility of an underlying asset but differ for a given asset over a given
volatility for an asset over the rather many measures based on the time period to the extent that investors’
200 next three months than over the various different options available on it. estimates of volatility as measured by
next year. A benchmark of implied volatility for an options prices prior to the period in
Thus options that expire in one underlying asset is generally calculated question differ from the actual volatility
0
year’s time will be priced with a by taking a weighted blend of multiple of the asset over that time.
Feb 90

Feb 92

Feb 94

Feb 96

Feb 98

Feb 00

Feb 02

Feb 04

Feb 06

Feb 08

arbitrage indices, such as the S&P 500 Disclaimer

This article is written by Standard & Poor’s, 55 ­Water Street, New York, NY 10041. Copyright © 2008. Standard & Poor’s (S&P) is a
S&P Volatility Arbitrage Index S&P 500 Volatility Arbitrage Index, have shown division of The McGraw-Hill Companies, Inc. All rights reserved. Standard & Poor’s does not undertake to advise of changes in the
information in this document. “S&P” and “S&P 500” are registered trademarks of The McGraw-Hill Companies, Inc. Other indices
consistent positive performance and low are trademarks of respective index providers.
These materials have been prepared solely for ­informational purposes based upon ­information generally available to the public
Source: Standard & Poor’s. Data from February 1990 to June 2008. volatility. As with any arbitrage strat- from sources ­believed to be reliable. Standard & Poor’s makes no representation with respect to the accuracy or ­completeness
of these materials, whose content may change without notice. Standard & Poor’s disclaims any and all liability relating to these
egy that gains in popularity, increase in ­materials, and makes no express or implied representations or warranties concerning the statements made in, or omissions
from, these materials. No portion of this publication may be reproduced in any format or by any means including electronically
arbitrageurs may tighten the spreads or ­mechanically, by photocopying, recording or by any information storage or retrieval system, or by any other form or manner
­whatsoever, without the prior written ­consent of Standard & Poor’s.
Alternative formulations of volatility strategy has outperformed the US equity negative return in only 31 months. The between implied and realised volatilities Standard & Poor’s does not guarantee the ­accuracy and/or completeness of any Standard & Poor’s Index, any data included
therein, or any data from which it is based, and Standard & Poor’s shall have no liability for any errors, omissions, or interruptions
arbitrage indices could use a different market as measured by the S&P 500 by strategy has yet negative return for any in the future. therein. Standard & Poor’s makes no warranty, express or implied, as to results to be obtained from the use of the S&P Indices.
variance swap tenor (for example more than 300 basis points per year. 12-month period and has a much lower However, as long as there is an Standard & Poor’s makes no express or implied warranties, and expressly disclaims all warranties of merchantability or fitness for a
particular purpose or use with respect to the S&P Indices or any data included therein. Without limiting any of the foregoing, in no
one-month instead of three-months), a More importantly, the strategy has maximum drawdown. insurance premium in the options event shall Standard & Poor’s have any liability for any special, punitive, indirect, or consequential damages (including lost profits),
even if notified of the possibility of such damages.
different source of the strike (traders’ resulted in consistent positive returns. It market, there will be room for volatility Standard & Poor’s does not sponsor, endorse, sell, or promote any investment fund or other vehicle that is offered by third parties
and that seeks to provide an investment return based on the returns of S&P Indices. A decision to invest in any such investment
variance swap quotes instead of VIX), has a very low annualised standard Conclusion arbitrage. The key issue that will drive fund or other vehicle should not be made in reliance on any of the statements set forth in this document. Prospective investors are
advised to make an investment in any such fund or vehicle only after carefully considering the risks associated with investing in such
and a different vega. deviation of 4.38 per cent versus 14.75 Volatility arbitrage is morphing from returns in the future will be the size of the funds, as detailed in an offering memorandum or similar document that is prepared by or on behalf of the issuer of the investment
fund or vehicle.
The S&P 500 Volatility Arbitrage Index per cent for the S&P 500. Out of 220 a niche institutional strategy to mass protection-seeker market versus the size The S&P 500 Volatility Arbitrage Index was officially launched on January 17, 2008. The returns of the index from February 20,
1990 to January 17, 2008 are back-tested by applying the published index methodology.
has history back to February 1990. The monthly observations, it has had a market, index-linked products. Volatility of the arbitrageur market.

the markit magazine – Autumn 08 Autumn 08 – the markit magazine