EQUITY RESEARCH | EUROPEAN DERIVATIVES

1 March 2010

SPECIAL REPORT Volatility investing with the VSTOXX

We discuss the construction, performance and benefits of an investable, constanttenor VSTOXX futures index that provides exposure to European implied volatility. In our view, the future potential of securities that reference this index is significant for European equity portfolio managers and volatility professionals alike. Our historical analysis shows that protecting European stock portfolios with a VSTOXX product has a superior risk-return profile to a proxy hedge using a comparable VIX product. This is likely related to lower basis risks and less expensive future roll costs.
Abhinandan Deb +44 (0)20 777 32481 Abhinandan.Deb@barcap.com Barclays Capital, London Anshul Gupta +44 (0)20 313 48122 Anshul.Gupta@barcap.com Barclays Capital, London Arnaud Joubert +44 (0)20 777 48344 Arnaud.Joubert@barcap.com Barclays Capital, London Colin Bennett +44 (0)20 777 38332 Colin.Bennett@barcap.com Barclays Capital, London Jerome Favresse +44 (0)20 313 48452 Jerome.Favresse @barcap.com Barclays Capital, London Ali Fardoun +44 (0)20 313 48435 Ali.Fardoun@barcap.com Barclays Capital, London Fabrice Barbereau +44 (0)20 313 48442 Fabrice.Barbereau@barcap.com Barclays Capital, London www.barcap.com

The success of exchange-listed volatility products offering exposure to the VIX index has highlighted the growth opportunity for European equivalents that reference the VSTOXX index. In this piece, we provide a brief history of the evolution of volatility trading, introduce the VSTOXX index and underlying futures, assess the equity portfolio diversification properties of an investable VSTOXX futures index and evaluate its credit portfolio hedging potential. We also address concerns about volatility future roll yields and answer why we feel there is a need for yet another volatility index. 2 3 3 5 7 7 7 10 10 12 12 14 14

EVOLUTION OF VOLATILITY TRADING LISTED OFFERINGS IN DEMAND ENTER THE VSTOXX SPOT, FUTURES AND BEYOND VSTOXX futures: an encouraging re-launch Constructing an investable VSTOXX futures index WHY ANOTHER VOLATILITY INDEX? Yes, volatilities are correlated, but mind the basis VSTOXX future roll costs not as high as for VIX futures VOLATILITY EXPOSURE FOR EUROPEAN EQUITY PORTFOLIOS Determining optimal volatility allocation using efficient frontiers VSTOXX or VIX for a European portfolio local choice wins VSTOXX compares well against conventional hedging strategies HEDGING A CREDIT PORTFOLIO WITH EQUITY VOLATILITY Adding equity volatility exposure to a credit portfolio

Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. This research report has been prepared in whole or in part by research analysts based outside the US who are not registered/qualified as research analysts with FINRA.
PLEASE SEE ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 16.

Source for charts, tables: Bloomberg, Eurex, STOXX, Barclays Capital

Barclays Capital | Volatility investing with the VSTOXX

EVOLUTION OF VOLATILITY TRADING LISTED OFFERINGS IN DEMAND

Volatility products have evolved significantly over the past two decades

Equity volatility products have evolved significantly over the past two decades. From relatively humble beginnings involving vanilla options to variance swaps, listed volatility futures and Exchange-Traded Notes (ETNs), innovation in this space has not only matched investor appetite but also adapted to changing market conditions; for instance the demand for implied volatility exposure and the preference for exchange-listed products over OTC variants after the credit crisis, respectively. A case in point is the VIX index arguably the best-known investor fear gauge and listed products that reference this index. Indeed the liquidity and depth of VIX options, futures and now the VIX exchange-traded product market 1 is a testament to how many investors consider VIX products for their volatility speculation or hedging needs. While the original VIX index now VXO was launched in 1993, it was not until early 2004 that futures on the VIX in its current form (ie, using a calculation similar to that for variance swaps) were launched. Indeed up until the late 1990s when variance swaps were first introduced on the OTC equity derivatives market, volatility speculators were largely limited to using (delta) hedged vanilla options. Since then, the pace of innovation has picked up as products, strategies and the investor community itself have evolved. For instance, forward variance swaps (trading volatility term structure), conditional variance (trading volatility skew), options on variance, VIX futures and options and more recently, VSTOXX futures have made big strides, with an increasing following that is no longer restricted to leveraged investors alone. In what follows, we discuss volatility investing with the VSTOXX index (Bloomberg code V2X index), the European equivalent of the VIX. In particular, we discuss the construction, performance and applications of an investable, constant-tenor VSTOXX futures index that provides exposure to European implied volatility. While volatility investing is not new, we assess the equity portfolio hedging abilities of this index, address concerns about volatility carry, roll costs as well as answer why we feel we need yet another volatility index.

with the latest avatar being a listed product that invests in volatility futures

Pace of innovation picked up in the last decade, and volatility products are no longer the preserve of hedge funds alone

We shall describe volatility investing with the VSTOXX, specifically the performance and applications of a VSTOXX futures index

Figure 1: Volatility product timeline, split by listed and OTC offerings highlights a decade of innovation

Listed Listed

Realised variance futures

Vanilla options

VIX futures

VIX options

VIX ETN

VSTOXX futures

mid 1990s
Vanilla options Variance swaps Forward variance

2004

2005
Options on variance

2009

2010?

Conditional variance

OTC OTC

Gamma swaps

VIX futures currently have outstanding vega of ~$42mn (exposure per vol pt), VXX has outstanding vega of ~ $47mn

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Barclays Capital | Volatility investing with the VSTOXX

ENTER THE VSTOXX SPOT, FUTURES AND BEYOND

VSTOXX is a measure of 30-day implied variance (in vol terms), calculated using sub-indices that derive their value from SX5E option prices

The VSTOXX index is a measure of the markets expectation of 30-day DJ Euro STOXX 50 (SX5E) variance, expressed in volatility terms. It is calculated using SX5E option prices and is comparable to 1mth SX5E variance swap strikes. On a given business day, it is derived via a linear interpolation of the two nearest VSTOXX sub-indices. These sub-indices in turn correspond to the expected variance of SX5E returns out to a standard option expiry, as implied by the SX5E options for that expiry note that the precise sub-index calculation details can be found in the DJ STOXX index guide published by STOXX. Using a varying (timeweighted) proportion of the nearest two sub-indices for the VSTOXX calculation ensures that rolling 30-day exposure can be achieved given the additivity property of variance.

VSTOXX futures: an encouraging re-launch

Activity is growing in this market, despite an overall decline in volatility through most of 2009

VSTOXX futures were first launched in 2005 and then again in 2009 (in a mini-future format with 1/10th lower notional value). These futures offer exposure to 30-day forward-starting variance 2, as opposed to the VSTOXX index which is comparable to the 30-day spot variance strike. While VSTOXX futures have not enjoyed the success of their VIX counterparts so far, activity has been steadily increasing (Figure 2) since their re-launch. Indeed, against a backdrop of declining volatility for much of 2009, we believe this is an encouraging sign for VSTOXX-related products going forward. Figure 2: VSTOXX futures activity humble start but promising future
2500 2000 1500 1mth moving average 1000 500 0 Jun-09 500 250 0 Feb-10 Total open interest ~ 200K vega Daily volume ~ 30K vega 1250 1000 750

Jul-09

Aug-09

Sep-09

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Nov-09

Dec-09

Jan-10

Aggregated futures open interest (contracts)

Aggregated futures volumes (contracts, RHS)

VSTOXX futures are linked to the Feb, May, Aug, Nov quarterly cycle, settling to square root of implied variance of Mar, Jun, Sep, Dec SX5E options

Figure 3 shows the contract specifications of VSTOXX futures that were launched in mid2009. As the figure shows, futures contract months are linked to the Feb, May, Aug, Nov quarterly cycle, as settlement to the VSTOXX index in these months gives an investor exposure to expected variance out to the Mar, Jun, Sep and Dec cycle of SX5E option expiries. As always, the futures are a measure of expected forward 30-day volatility or variance, with a forward period that decreases daily until expiration. For instance, the Mar-10 future (FVSH0) will settle to the VSTOXX (as per the rules set out in Figure 3) on Wed 17 Mar 2010, 30 calendar days before the Apr-10 SX5E options
2

Technically, the exposure is to the square root of expected forward-starting variance, as settlement of the futures is linear in volatility and not variance. Due to the stripping away of variance convexity in the settlement, VSTOXX futures levels should be at most the fair value of the corresponding forward-starting variance strikes.

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Barclays Capital | Volatility investing with the VSTOXX

expiration on 16 Apr 2010. At the time of writing, this is comparable to the 1mth variance swap strike three weeks forward. Figure 3: VSTOXX futures contract specifications
Feature Name Bloomberg code Contract size (vega) Tick size, value Contract months Description VSTOXX Mini-Futures Contracts FVS, eg FVSH0 (Mar-10 future), FVS1 (Generic front month future) 100 per index point (so 100 vega per contract) 0.05 index points (tick value = 5) Three nearest calendar month contracts plus one from the Feb, May, Aug, Nov quarterly cycle 30 calendar days prior to corresponding SX5E option expiration, which is typically the Wed before second last Fri of the future expiration month, close of trading at 12:00 CET Average of VSTOXX index calculated between 11:30 and 12:00 CET on last trading day

Last trading day

Final settlement price

Since inception, the VSTOXX futures curve has been mostly in contango, with backwardation occurring when risk surfaces

Figure 4 shows a history of the VSTOXX futures curve, using the FVS2 FVS1 spread (ie, the first two generic VSTOXX futures). Since inception in June 2009, this curve has been mostly upward sloping (ie, in contango), similar to the implied volatility term structure in a low volatility environment. In early 2010, with the onset of the Greek sovereign crisis, the curve was backwardated briefly. We shall return to discuss the impact of the shape of the VSTOXX futures curve on a rolling position in VSTOXX futures in due course, but note it here first for completeness.

Figure 4: VSTOXX futures were mostly in contango since Jun-09

40% 36% 32% 28% 24% 20% 16% Jun-09 4% 3% 2% 1% 0% -1% -2% Aug-09 FVS2-FVS1 (RHS) Oct-09 FVS1 index Dec-09 FVS2 index Feb-10

There is a need for an investable index that doesnt require investors to worry about managing futures positions

While VSTOXX futures provide a transparent and listed 3 means of achieving implied volatility exposure, the experience of the VXX product (based on VIX futures) has shown that there is also a need for a well-constructed, investable index that does not require investors themselves to roll futures positions and that can potentially be bolted on easily as a protective overlay to equity portfolios.

The importance of a listed volatility instrument cannot be overstated given the increased sensitivity to counterparty credit risk since the onset of the credit crisis.

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Barclays Capital | Volatility investing with the VSTOXX

Constructing an investable VSTOXX futures index

Our US equity derivatives research team have written a comprehensive paper Towards an Investable Volatility Index, 3 February 2009 where they describe and justify the construction of self-funded, daily rebalanced VIX futures indices. In what follows, we construct and describe the performance of a similar (short-term) investable index based on VSTOXX futures, then outline potential applications that will be discussed in the subsequent section.
V2XFutIndex: Part-rolls a position from front-month VSTOXX future to the nextmonth VSTOXX future every day

Using the same methodology as the index underlying the VXX product (SPVXSTR index), we have calculated an investable index that tracks the returns of a daily rolling portfolio of VSTOXX futures. For notational convenience, we shall refer to this index as V2XFutIndex. In brief, its calculation methology is as follows: on a VSTOXX future expiration day, the V2XFutIndex is entirely invested in the subsequent VSTOXX future lets call this V1. From then on, an equal fraction of the position is rolled to the second month contract (V2) on each business day, such that at the close of the business day prior to V1s expiration, the index is entirely invested in V2. Therefore on a given day, the forward exposure of V2XFutIndex is precisely one month rather than a decreasing fraction of time that a position in a single future will allow. Figure 5 shows a history of the total return performance (including daily EONIA return) of V2XFutIndex, which we have rebased to the level of the VSTOXX on 2 Jan 2006 for easy comparison 4. While V2XFutIndex appears to react less to market stress periods than the VSTOXX at first glance, we must remember that the VSTOXX itself is not investable. Secondly, Figure 6 shows that the V2XFutIndex (like the VSTOXX) is strongly negatively correlated to equities, with -73% correlation using weekly returns since 2006. Figure 6: Futures index has strong negative correl to equities
Rolling futures index returns (5-day) 60% Investable index return correl to equity = -73% 30% y = -1.95x R = 0.53 0%
2

V2XFutIndex is investable and is strongly negatively correlated to equities

Figure 5: VSTOXX and V2XFutIndex (total) returns

90 80 70 60 50 40 30 20 10 Jan-06 Sep-06 May-07 V2X Jan-08 Sep-08 May-09 Jan-10

-30% -15%

-10%

-5%

0%

5%

10%

15%

Rolling futures index (TR)

SX5E returns (5-day)

So why do we need such a rolling futures index? We summarise our reasons as follows: 1. The VSTOXX index itself is not investable and VSTOXX futures are only suitable if investors are agreeable to the periodic maintenance involved in rolling futures. However, if this is too much overhead in terms of maintaining a volatility investment (given many investors already manage equity futures), then a constant tenor product will appear attractive.

We have used historical VSTOXX futures data from the older FVSX (1000x multiplier) contracts prior to Jun 09, courtesy Eurex. While these contracts are available from Oct 05, we start our period in Jan-06 for reliability of data, convenience in future hedge comparisons and so that we have roughly equal periods of rallying and stressed markets.

1 March 2010

Barclays Capital | Volatility investing with the VSTOXX

2.

Such a rolling index lends itself to a number of investable products that reference it, whether they take the form of unfunded structures like swaps or indeed an exchangelisted, funded vehicle 5. Indeed, funded volatility investments in particular represent a major step for some investors who have till now shied away from volatility products given their theoretically unlimited loss potential.

Indeed, a consequence of different VSTOXX products in the market could be increasing liquidity in the underlying futures (as dealers hedge their exposure to the reference products), paving the way for more innovation in the space (eg, VSTOXX options).
Vega exposure of V2XFutIndex changes over time due to self funding nature of the index

Figure 7 shows the historical volatility exposure (vega profile, in % terms) of an investment in V2XFutIndex. This changes over time and it does so due to the self-funded nature of the index. Simply put, the V2XFutIndex is constructed to not have equal volatility exposure at all times in order to avoid it from ever attaining negative values 6. The figure shows that such a construction can be beneficial for investors who are going long volatility via this index. When volatilities spike up, the % vega exposure drops and a long volatility position is likely to suffer less should volatilities retrace the gains (which is more likely than not given volatility is a mean-reverting quantity). When volatilities are low or decreasing, the % vega exposure is high, which means a sudden increase in volatility will be beneficial to a long volatility investor. Figure 7: Vega exposure (in % terms) of V2XFutIndex varies given self-funded nature
8% 7% 6% 5% 4% 3% 2% % vega declines when vols spike up, can be beneficial as risks are weighted towards a vol decline then Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 % vega exposure for an investment in V2XFutIndex Weighted volatility (front and second month) - RHS 70 60 50 40 30 20 10 0 Jan-10

this can be beneficial for long volatility investors

1% Jan-06

The next question that is likely to arise in many investors minds is why we need another volatility index when the VIX and associated products already represent a liquid benchmark for vehicles that provide exposure to short dated implied volatility. Indeed, arent volatilities correlated when risks surface? We attempt to address such concerns and more in the following section.

5 6

like the VXX exchange-traded note, which references the SPVXSTR, a short-term VIX futures index This could happen if an index is constructed to have constant vega exposure, as then a persistent volatility decline would lead to negative index values.

1 March 2010

Barclays Capital | Volatility investing with the VSTOXX

WHY ANOTHER VOLATILITY INDEX?

The VSTOXX index and indeed the associated futures have been around for several years. While the Jun-09 relaunch in mini-futures contract form have seen an encouraging pick up in VSTOXX futures volumes, they pale in comparison so far to the success of VIX products (eg, outstanding VIX futures contracts have about $42mn vega exposure). So why do we need another volatility index in Europe and importantly, what can drive its popularity going forward?

Yes, volatilities are correlated, but mind the basis

SPX and SX5E vols are correlated, but their spread is distinct and its variation significant recent region specific crises, composition differences highlight basis

SPX and SX5E implied volatilities are strongly correlated, as Figure 8 demonstrates using respective 1mth variance swap strikes (over 90% correlation since 2001). However, not only are the volatilities distinct but the variation of their spread is significant over time, as Figure 9 shows. Indeed, a number of investors have and continue to trade relative views of European and US volatility via variance swaps, highlighting the basis between the two. Furthermore, index membership changes, varying relative sector compositions, region specific events in the past (eg, TMT bubble bursting had a greater impact for European telecoms than in the US), present (eg, Greek sovereign uncertainties that are more Europe specific) and potentially in the future are likely to ensure that the basis persists, despite overall rising global equity correlations. This difference also has a meaningful impact for investors considering volatility overlays to regional equity portfolios, something we shall explore in more detail in the subsequent section. In particular, we find that the risk-return profile of a European portfolio (based on the SX5E) overlaid with an optimal equity-volatility allocation using the V2XFutIndex (Europe) is superior to that of one using the SPVXSTR (US).

Figure 8: US and European volatilities are correlated

100% 1mth SX5E variance swap strike 80% 60%

Figure 9: but their spread variation is significant

20% 15% Avg = 4.1%, stdev = 4.5% 10% 5% On average, SX5E 1mth var strike is 4 vols higher than SPX

40% 20% 0% 0%

y = 0.80x + 0.01 R = 0.86

2

0% -5% Jan-02 Sep-02 Jan-04 Sep-04 Jan-06 Sep-06 Jan-08 Sep-08 May-01 May-03 May-05 May-07 May-09 Jan-10
7

20%

40%

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100% SX5E - SPX 1mth variance swap strike spread

1mth SPX variance swap strike

VSTOXX future roll costs not as high as for VIX futures

One of the criticisms levelled against volatility investments in general is the high cost of carry during non-stressed market periods. In fact, many investors frequently ask the question, how do I reduce carry cost without giving up too much hedge or overlay performance? Typically, answers to this involve spreading protection positions, collaring market upside exposure, employing rule-based volatility allocations and other strategies. In the case of a rolling volatility futures index, the term structure roll-down (or implied
1 March 2010

Barclays Capital | Volatility investing with the VSTOXX

volatility carry cost) of a fixed maturity volatility position (all else equal) translates to the daily futures roll cost. We contend that an investment in V2XFutIndex has lower volatility carry costs than a comparable one in the SPVXSTR, given a less costly daily futures roll.
SX5E 2mth-1mth term structure is 37bp flatter than that of the SPX

The basis for this statement is Figure 10, which charts the 2mth-1mth var term structure of the SX5E versus that of the SPX, with the term structure of the former being 37bp flatter on average than that of the latter. What does this mean for a product that rolls a near-term position in volatility to a longer-dated contract?

Figure 10: SX5E has flatter vol term structure than SPX less -ve V2XFutIndex roll yield
4800 SX5E term is steeper 4000 SX5E term is flatter 3200 SX5E-SPX spread statistics Avg (rallying markets): -28bp Avg (all markets): -37bp Feb-02 Feb-03 Feb-04 Feb-05 Feb-06 Feb-07 Feb-08 Feb-09 -2% 0% 2%

2400

-4%

1600 Feb-01

-6% Feb-10

SX5E-SPX (2mth-1mth var term structure spread - RHS)

SX5E index

All else equal, a daily rolling position in futures decays to zero if the volatility term structure remains upward sloping this effect is less pronounced for the SX5E than the SPX

Lets set aside changes in the absolute level of volatility to answer this question easily. If the volatility term structure is upward-sloping (as is the case in normal market conditions) and volatility remains unchanged, then a daily rolling position using our self-funding methodology shall slowly decay to zero as the roll costs mount up (given were buying a portion of a more expensive contract than the one were selling each day). What Figure 10 suggests is that this effect isnt as pronounced for the SX5E as it is for the SPX, which on average has a steeper volatility term structure than the SX5E. If we now isolate the low to declining volatility regimes in Mar-03 through Jul-07 and from Mar-09 through Jan-10 (when roll/carry costs are increasingly important), the SPX term structure is just shy of 30bp steeper than the SX5E. What does this mean for a position that rolls about 5% of its value daily from the front month to the second month contract? On average, the annual roll cost differential is of the order of 28bp x 5% x 252 = 3.5 volatility points! Lets see if this is borne out in the performance of the two rolling futures indices since the latest volatility peak (for both markets) on 20 November 2008. Figure 11 shows the relative performance of volatility since the peak, as well as that of the two futures indices since then. While SPX volatility has declined 7.5% more than SX5E (1mth tenor), the SPVXSTR has declined 10.3% more than the V2XfutIndex. With 1mth variance strikes peaking around 80 vols in Nov 2008, this corresponds to a differential of (10.3%-7.5%) x 80 = 2.2 volatility points (for a period of just over a year).

On average, we estimate the annual roll cost differential to be 3.5vols

and looking at declines in volatility as well as the futures indices, this differential was 2vols (Nov-08 to Jan-10)

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Barclays Capital | Volatility investing with the VSTOXX

Figure 11: V2XFutIndex has outperformed the SPVXSTR since the vol peak in Nov 2008

SX5E 1mth var strike SPX 1mth var strike Spread (Eur-US) Bars show % declines in volatility/value, from Nov-08 peak to 5 Jan 2010 V2XFutIndex SPVXSTR Spread (Eur-US) -80% -60% -40% -20% 0%

-69.4% -76.9%
7.5%

-67.5% -77.8%
10.3%

20%

While this is less than what we expected (3.5 volatility points), our estimation assumed volatility term structures are upward-sloping (volatility futures are in contango) over the entire period, which is not the case in reality. Nevertheless, this analysis supports our assertion that rolling costs are lower for the V2XFutIndex. Another way of examining the roll cost differential between the two futures indices, this time using volatility futures data, is by comparing the performance of the VSTOXX and VIX generic futures (FVS1 and UX1, respectively) versus their futures indices. This means that we can strip out the volatility future performance from the roll.
Using futures data since Jun-09, V2XFutIndex outperformed SPVXSTR by 14%, adjusting for underlying future returns

When we do this exercise for data starting from Jun-09 (which is when the VSTOXX minifutures were launched and since when volatilities have broadly declined), we find a significant divergence between the two indices. Figure 12 and Figure 13 show that while V2XFutIndex underperformed the front month future by 19%, the SPVXSTR underperformed the UX1 by over 33%. Figure 13: while the SPVXSTR has underperformed the generic front month future by 33%
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Figure 12: Since launch, V2XFutIndex has underperformed generic front month future by 19%...
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V2XFutIndex

FVS1 (Generic first VSTOXX future)

SPVXSTR index

UX1 (Generic first VIX future)

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Barclays Capital | Volatility investing with the VSTOXX

VOLATILITY EXPOSURE FOR EUROPEAN EQUITY PORTFOLIOS

It is well documented that adding volatility to an equity portfolio can improve risk-return profiles. This result is driven by the robust negative correlation between equity and volatility, with volatility offering a diversification benefit that in turn helps optimise risk-adjusted returns.
Investable volatility indices have made volatility more accessible than before

For investors looking to deploy such overlays, the advent of investable volatility indices has made it both simple and more accessible than before, particularly given constant tenor exposure to implied volatility. However, a pertinent question that arises at this point is the relative value between overlaying a portfolio by investing in these indices and hedging via puts/put spreads, for instance. In this section, we attempt to address this issue by analysing different strategies and comparing them on the basis of their risk-reward trade-offs. Before moving on to that however, let us first establish the optimal volatility allocation (for both VSTOXX and VIX exposure via their investable indices) for a European equity portfolio that tracks the SX5E 7.

Determining optimal volatility allocation using efficient frontiers

Different equity-vol splits are back-tested (exclusive of transaction costs), with a sensible rebalancing strategy

In order to arrive at an optimum volatility-to-equity split, we first test different allocations (eg, 90% equity + 10% volatility, 80% equity + 20% volatility, etc) for both the V2XFutIndex and the SPVXSTR versus a SX5E portfolio, from Jan-06 through to Jan-10. We adopt the following rules regarding allocations and rebalancing: the equity + volatility portfolio is rebalanced exclusive of transaction costs every three months such that:

When the volatility allocation rises above its desired level, we reduce its weight in the rebalance, allocating the volatility gains to the equity component. When the volatility allocation falls below its desired level, we increase it by as much as equity gains, if any, will allow, up until the specified volatility allocation.

Note that this rebalancing method is chosen given its proximity (in our view) to how real strategies and portfolios are managed/rebalanced 8. The resulting impact on the vega exposure of our three monthly rebalancing is shown in Figure 14. Figure 14: vega of a 10mn portfolio (85 SX5E, 15 vol), with and without rebalancing
250k 200k 150k 100k 50k 0 Jan-06 Vol becomes too large a proportion of the portfolio in Q3-Q4 08; rebalancing reduces vega so that vol allocation (vega*vol level) is 15% of total portfolio value

Jul-06

Jan-07

Jul-07

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Jul-08

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Jan-10

vega exposure of 10mn portfolio in Jan-06 (85-15 equity vs vol) - quarterly rebalancing vega exposure of 10mn portfolio in Jan-06 (85-15 equity vs vol) - NO rebalancing

For back-testing purposes, we have used an ETF tracking the SX5E. We could have considered rebalances based on a significant change in allocation, ie not periodically. But this is in practice unlikely and can also lead to very frequent (and potentially costly) rebalances when volatilities move rapidly.
8

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Barclays Capital | Volatility investing with the VSTOXX

Now, using the method described above, we compute the historical value of the long equity, long volatility portfolio (for different allocations). Then, it is a simple matter of computing each strategys average monthly return (y-axis) and the standard deviation of monthly returns (risk, x-axis). These statistics are charted in Figure 15. Figure 15: Efficient frontier for equity-volatility split (85-15 allocation optically superior)
RETURN - avg monthly annualised 25% 20% 15% 10% 5% SX5E + SPVXSTR 0% (100% SX5E, 0% vol) -5% 10% 15% 20% 25% 30% 35% RISK - stdev of monthly returns (annualised) 40% (85% SX5E, 15% vol) SX5E + V2XFutIndex

The 85-15 equity-vol split appears most optimal given riskreturn and max drawdown-risk considerations

Each point on either curve in Figure 15 represents an allocation that is 5% away from its neighbour. We have highlighted for reference the (100% equity, 0% vol) and (85% equity, 15% vol) points for the SX5E overlaid with an investment in V2XFutIndex. While having volatility allocations > 15% do improve the return-risk ratio marginally, we favour the 85-15 split from both an optically favourable and pragmatic viewpoint. Our choice is given more credence by Figure 16, which depicts the maximum drawdown of each strategy allocation versus its risk. It highlights that increasing the volatility allocation above 15% has marginally less impact on reducing worst performance. Figure 16: Worst drawdown curve suggests little benefit of allocating > 15% to volatility
MAX DRAWDOWN - worst monthly return annualised 10% -100% 15% 20% 25% 30% 35% 40%

(85% SX5E, 15% vol) SX5E + V2XFutIndex

-200% Adding more volatility does little to reduce worst monthly drawdown -300% (100% SX5E, 0% vol) -400% RISK - stdev of monthly returns

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Barclays Capital | Volatility investing with the VSTOXX

VSTOXX or VIX for a European portfolio local choice wins

While helping us in determining the optimum volatility allocation to a European equity portfolio, Figure 15 also highlights that it is better to hedge this portfolio using European volatility exposure (rather than US), given a superior risk-return profile.
VSTOXX-based SX5E portfolio overlay has a better risk-return profile than a similar overlay using a VIX-based product

To better visualise this, we use an 85-15 (equity-volatility) split and chart the historical performance of a equity overlay strategy that employs V2XFutIndex versus one that uses the SPVXSTR. Figure 17 is the result, showing unhedged equity performance from Jan-06 to Jan-10 as well for reference. Not only does the V2XFutIndex overlay outperform the SPVXSTR in a rallying equity market, the Sharpe ratio statistics in Figure 19, Figure 20 and Figure 21 show better risk-adjusted returns through the cycle. Figure 17: Using V2XFutIndex outperforms SPVXSTR larger VIX future roll costs?

125

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Jul-06 SX5E

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Jan-10

SX5E + V2XFutIndex (85-15)

SX5E + SPVXSTR (85-15)

Performance differential likely due to higher VIX future roll costs and SX5E-SPX basis

Why such a noticeable performance differential? To answer this, we look at how the two strategies performed during the equity-bull phase from 2006 to mid-2007, noting that the majority of underperformance occurred here. We believe that higher future roll costs for VIX futures (in the normal market regime with a steep volatility term structure) as well as the SX5E-SPX basis had a part to play in this.

VSTOXX compares well against conventional hedging strategies

For a fair comparison between pure volatility and option-based strategies, we choose the same rolling/rebalancing tenor for both, ie three months. For the V2XFutIndex, we rebalance our exposure every 3mths as discussed earlier (ie 85-15 equity-vol split). In the case of puts and put spreads, we roll the options on the last day of the month prior to their expiration 9. Throughout our analysis, we use 3mth ATM puts and 3mth ATM-85 put spreads.
Three points to bear in mind for comparison: Performance in benign markets, performance in stressed markets, initial capital considerations

First, we examine how each strategy performs when markets are rallying. This helps establish the cost of carry of the hedging strategy. Second, we scrutinize how reactive it is when risk surfaces in the markets. A third consideration is the upfront premium required for entering a particular strategy. Since we have used total returns of the V2XFutIndex in all our analysis, we can compare each hedging strategy on an equal capital requirement footing.

This ensures that we retain some (albeit low) volatility exposure in the puts as we do not hold them till expiration.

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Figure 18: Performance of different volatility, option overlay strategies vis--vis SX5E

125

100

75

50 Jan-06

Jul-06 SX5E

Jan-07

Jul-07

Jan-08

Jul-08 Jan-09 Jul-09 SX5E + 3mth ATM Put SX5E + V2XFutIndex (85-15)

Jan-10

SX5E + 3mth ATM-85 Put spread

Superior through-cycle risk ratios for a SX5E portfolio overlaid with an investment in V2XFutIndex

Figure 18, Figure 19, Figure 20 and Figure 21 show the results. While the carry cost of a put is greater than a put spread in the bull-regime, the put performs better when markets start tumbling, as in 2008. Also, while the maximum drawdowns of the volatility overlays are greater than that of a put hedge, they react more strongly than puts to extreme events (as in Sep-Oct 2008), more than making up for the loss in the equity portfolio. Importantly the risk ratios of the V2XFutIndex overlay are superior to the other hedges through the cycle.

Figure 19: BULL-BEAR CYCLE (Jan-06 to Jan-10) performance, maximum draw-downs and risk-return profiles
Avg 1mth returns -0.3% -0.3% -0.2% 0.5% 0.1% Std Deviation 6.6% 2.7% 3.8% 4.4% 4.4% Downside Std Deviation 5.2% 1.7% 3.0% 3.0% 3.2% Maximum drawdown -28.2% -7.7% -18.5% -16.9% -16.1% Ann. risk-adjusted return -0.1 -0.4 -0.2 0.4 0.1 Ann. downside risk adjusted return -0.2 -0.6 -0.3 0.5 0.1

STRATEGIES SX5E SX5E + ATM Put SX5E + ATM-85 Put spread SX5E + V2XFutIndex (85-15) SX5E + SPVXSTR (85-15)

Figure 20: BULL PERIODS (Jan-06 to Jul-07 and Mar-09 to Jan-10) performance, maximum draw-downs and risk-return profiles
Avg 1mth returns 2.0% 0.7% 1.1% 1.4% 1.0% Std Deviation 5.4% 2.5% 3.0% 3.8% 3.8% Downside Std Deviation 4.1% 1.3% 1.5% 3.4% 2.9% Maximum drawdown -21.1% -5.6% -7.6% -16.9% -16.1% Ann. risk-adjusted return 1.3 0.9 1.2 1.3 0.9 Ann. downside risk adjusted return 1.7 1.8 2.4 1.4 1.2

STRATEGIES SX5E SX5E + ATM Put SX5E + ATM-85 Put spread SX5E + V2XFutIndex (85-15) SX5E + SPVXSTR (85-15)

Figure 21: BEAR PERIOD (Aug-07 to Feb-09) performance, maximum draw-downs and risk-return profiles
Avg 1mth returns -3.7% -1.7% -2.2% -0.9% -1.2% Std Deviation 6.7% 2.2% 4.1% 4.8% 4.7% Downside Std Deviation 5.4% 2.0% 3.5% 2.8% 3.2% Maximum drawdown -28.2% -7.7% -18.5% -12.1% -13.6% Ann. risk-adjusted return -1.9 -2.7 -1.9 -0.7 -0.9 Ann. downside risk adjusted return -2.4 -3.1 -2.2 -1.2 -1.3

STRATEGIES SX5E SX5E + ATM Put SX5E + ATM-85 Put spread SX5E + V2XFutIndex (85-15) SX5E + SPVXSTR (85-15)

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HEDGING A CREDIT PORTFOLIO WITH EQUITY VOLATILITY

We briefly consider other potential applications of the V2XFutIndex, particularly in a different asset class where investors may not be familiar with the intricacies of equity volatility, but interested nevertheless in low-maintenance hedging overlays. Our first thought is to consider credit, given a strong link between credit spreads and equity volatility.
Merton model posits a relationship between risks embedded in a credit portfolio and equity vol, this is empirically observed even at the macro level

The Merton-model view of a firm 10 dictates that default probability of a firm, as priced into a long credit position should be influenced by both the firms stock price and its stock volatility. Indeed an empirical relationship is observed at the macro (index) level too, as the scatter plot (Figure 22) between the VSTOXX index and a long credit 5yr excess return index 11 demonstrates, using data from Jan-06 to Jan-10. While the negative correlation appears robust (over 80%), the relationship appears to be non-linear when systemic risks surface, ie at high volatility levels. Figure 23: Credit portfolio versus investable equity volatility
103 102 520 450 380 Relatively muted reaction of volatility to credit move here 310 240 170 100

Figure 22: Negative credit-equity vol correlation is robust

90 VSTOXX index (V2X)

70 Jan-06 to Jan-10 50 y = -6.32x + 663.90 R = 0.70 30

2

101 100 99 98 97

10 96 98 100 102 104 Europe Long-Credit 5y Main ER

96 30 Jan-06 Sep-06 May-07 Jan-08 Sep-08 May-09 Jan-10 Europe Long-Credit 5y Main ER V2XFutIndex (rebased to 100 in Jan-06, RHS)

Adding equity volatility exposure to a credit portfolio

To arrive at a hedge ratio, our first attempt is a through-thecycle beta; this results in a 98-2 credit- equity vol split

Given the negative correlation of a credit portfolio to equity volatility, it is natural to investigate the possibility of hedging credit risk with equity volatility. When we regress the weekly returns of the time series in Figure 23 from Jan-06 to Jan-10, we arrive at a 98-2 credit equity volatility split. We use a through-the-cycle beta in this way as we wish to establish proof of concept and to remain consistent with the timeframes used within the piece so far. We shall look to fine-tuning this credit equity volatility split in future work. Our strategy rebalance methodology remains the same as the one we used in the equityvolatility portfolio ie the portfolio of 98% credit and 2% V2XFutIndex is rebalanced every three months, with the same provisos as before (see page 10). Figure 24 shows the results of this strategy, versus that of holding a credit portfolio outright. While the overlay was able to hedge against rapidly increasing credit risk during the peak of the credit crisis, the volatility allocation proved insufficient in early 2008, when monoline downgrades led significant value destruction in the credit markets (as Figure 23 also shows) but which was not reflected by equity volatility to the same extent.
Merton views a firms liabilities as contingent claims issued against the firms underlying assets. The default probability of a firm is a function of stock price, stock price volatility and the debt to equity ratio, i.e. the firms leverage 11 This Barclays Capital index tracks the performance of a long credit position in the CDS market, using the iTraxx Main 5yr on-the-run series as the underlying index. Excess returns are used to strip out changes in interest rates.
10

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Figure 24: European credit portfolio performance outright + hedged with V2XFutIndex
106 104 102 100 98 96

Monolines dow ngraded

94 Jan-06 Sep-06 May-07 Jan-08 Sep-08 May-09 Jan-10

Europe long credit 5yr

Europe long credit 5yr + V2XFutIndex (98-2)

Equity vol provides diversification in terms of improving risk-return profile of credit-only portfolio

Figure 25 shows the performance statistics of the portfolio with and without the equity volatility overlay. Importantly, we are not comparing a volatility hedge against a CDS hedge using this analysis our analysis is more aimed at establishing the diversification benefits that the investable V2XFutIndex offers in asset classes other than equities.

Figure 25: BULL-BEAR CYCLE (Jan-06 to Jan-10) performance, maximum draw-downs and risk-return profiles
Avg 1mth returns 0.02% 0.11% Std Deviation 0.84% 0.76% Downside Std Deviation 0.65% 0.52% Maximum drawdown -3.5% -2.3% Ann. riskadjusted return 0.07 0.49 Ann. downside risk adjusted return 0.09 0.73

STRATEGIES Europe long credit 5yr Europe long credit 5yr + V2XFutIndex (98-2)

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ANALYST CERTIFICATION(S)
We, Abhinandan Deb, Arnaud Joubert, Colin Bennett, Jerome Favresse and Anshul Gupta, hereby certify (1) that the views expressed in this research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this research report. IMPORTANT DISCLOSURES For current important disclosures regarding companies that are the subject of this research report, please send a written request to: Barclays Capital Research Compliance, 745 Seventh Avenue, 17th Floor, New York, NY 10019 or refer to https://ecommerce.barcap.com/research/cgibin/all/disclosuresSearch.pl or call 1-212-526-1072. The analysts responsible for preparing this research report have received compensation based upon various factors including the firm's total revenues, a portion of which is generated by investment banking activities. Research analysts employed outside the US by affiliates of Barclays Capital Inc. are not registered/qualified as research analysts with FINRA. These analysts may not be associated persons of the member firm and therefore may not be subject to NASD Rule 2711 and incorporated NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analysts account. Barclays Capital produces a variety of research products including, but not limited to, fundamental analysis, equity-linked analysis, quantitative analysis, and trade ideas. Recommendations contained in one type of research product may differ from recommendations contained in other types of research products, whether as a result of differing time horizons, methodologies, or otherwise. Risk Disclosure(s) Options are not suitable for all investors. Please note that the trade ideas within this research report do not necessarily relate to, and may directly conflict with, the fundamental ratings applied to Barclays Capital Equity Research. The risks of options trading should be weighed against the potential rewards. Risks: Call or put purchasing: The risk of purchasing a call/put is that investors will lose the entire premium paid. Uncovered call writing: The risk of selling an uncovered call is unlimited and may result in losses significantly greater than the premium received. Uncovered put writing: The risk of selling an uncovered put is significant and may result in losses significantly greater than the premium received. Call or put vertical spread purchasing (same expiration month for both options): The basic risk of effecting a long spread transaction is limited to the premium paid when the position is established. Call or put vertical spread writing/writing calls or puts (usually referred to as uncovered writing, combinations or straddles (same expiration month for both options): The basic risk of effecting a short spread transaction is limited to the difference between the strike prices less the amount received in premiums. Call or put calendar spread purchasing (different expiration months & short must expire prior to the long): The basic risk of effecting a long calendar spread transaction is limited to the premium paid when the position is established.

Because of the importance of tax considerations to many options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions. Supporting documents that form the basis of our recommendations are available on request. The Options Clearing Corporations report, http://www.theocc.com/publications/risks/riskchap1.jsp Characteristics and Risks of Standardized Options, is available at

Barclays Capital offices involved in the production of equity research: London Barclays Capital, the investment banking division of Barclays Bank PLC (Barclays Capital, London) New York Barclays Capital Inc. (BCI, New York) Tokyo Barclays Capital Japan Limited (BCJL, Tokyo) So Paulo Banco Barclays S.A. (BBSA, So Paulo) Hong Kong Barclays Bank PLC, Hong Kong branch (BB, Hong Kong) Toronto Barclays Capital Canada Inc. (BCC, Toronto)

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