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The classic investment in volatility has been a delta hedged straddle or more
recently a volatility/variance swap. Although useful, the payoff of both of these
instruments has the disadvantage of being tied to the difference between realized
volatility and implied volatility – not the level of implied volatility itself. More
recently volatility indices have become popular. These have been successful in
identifying trends in volatility, but it has not been easy to design products that
represent direct investments in the indices.
This report begins with a short review of the popular approaches to estimating
implied volatility. It reviews the theory behind recent implied volatility indices,
then it shows why investing directly in these indices has proven a challenge.
Finally, it ends with possible investible products.
Figure 1: Implied Volatility Report on European Indices for 3rd February 2004
Change in 3- Fixed Strike: Change in
Latest 3-Month Implied
Index 1 Day Return Month ATM 3-Month Implied
Price Volatility
Implied Volatility Volatility
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Volatility as an Asset Class, Lehman Brothers 2002
INITIAL VERSION OF THIS REPORT HAS BEEN CIRCULATED PRIOR TO 19th FEBRUARY 2004
Equity Derivatives & Quantitative Research
Ever since the Black Scholes options pricing model was developed it has been
possible to estimate the level of volatility a stock must have in order to justify its
current price. This estimated volatility is generally called implied volatility. This
is still the most widely used way of measuring volatility. Figure 1 shows a
volatility report on the European indices.
Figure 1 shows what is called the At-The-Money (ATM) implied volatility for
each index for a term of three months ahead. This is calculated by choosing the
options for each index which have strike prices close to the spot price of the
option’s underlying index and then interpolating. Unfortunately, this estimate is
not stable in the sense that the implied volatility calculated from an option with a
different strike price could be meaningfully different from that calculated from
the ATM option.
2
The volatilities in Figure 1 are determined from an estimated implied volatility surface that is
determined from actual option prices. This makes it possible to estimate the ATM volatility even
when the index level is not at a particular listed option’s strike price.
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Equity Derivatives & Quantitative Research
35%
30%
25%
Implieds 20%
15%
10%
80% 90% 100% 105% 110% 120%
Strike
Volatility Indices
Pioneering volatility indices were created by the CBOE and by the Deutsche
Börse, among others. These include the “old” VIX® and the VDAX®. Both of
these indices are based on average implied volatility levels of options that are
close to being at-the-money. These indices were successful in capturing, at least
in a broad sense, the trend in implied volatility. Direct investment in these indices
was hampered, however, by the fact that no one option or portfolio of options
would track the changes in implied volatility that occurred as the level of the
market changed leading to changes in the ATM strike. Thus even though futures
existed on both indices, market makers found it hard to hedge their positions in
the futures and liquidity stayed low.
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Equity Derivatives & Quantitative Research
The implication is that the higher realized volatility is, the more profitable the
variance swap will be. But, of course, there is no free lunch because any option
position with a positive gamma will also have a negative “theta”. That is, it will
decline in value over time. It turns out that the rate of decline over time is a
function of the option portfolio’s “implied volatility”. Therefore, the net profit
from a variance swap depends on two offsetting factors. The first is the level of
realized volatility. The second factor is the option portfolio’s implied volatility
was when it was initiated. Clearly the variance swap payoff is tied to the
difference between implied volatility and realized volatility. Conceptually, it
“converts” the implied volatility embedded in the options portfolio into realized
volatility generated from delta hedging as the swap goes from inception to
expiration.
Clearly the value of the options portfolio used in a variance swap is a function of
implied volatility (technically implied variance). Therefore, it seems natural to use
its value as a proxy for the level of implied variance. One of the most remarkable
features of the variance swap option portfolio is that its value at inception (with a
minor adjustment) is in fact exactly equal to a very reasonable estimate of implied
volatility. This mathematical fact forms the basis of the most recent generation of
implied volatility indices.
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Equity Derivatives & Quantitative Research
The new VIX® announced by the CBOE September 2003 is an example of the
latest generation of implied volatility indices. It is an important advance over the
prior generation because it does not use any option pricing model to determine the
level of implied volatility.3 It provides a single summary estimate of volatility
across the whole volatility surface in a natural way. Finally, it summarizes the
characteristics of the whole volatility surface instead of being tied to ATM or near
ATM strike options. It tends to be more correlated with the performance of
volatility sensitive investment strategies. It accomplishes this because it is based,
in essence, on the value of the generalized straddle used typically in constructing
a variance swap, as discussed above. Note, however, that by nature this index and
any other index based on the same methodology is fundamentally tied to implied
variance, not implied volatility. The volatility can always be calculated from the
variance, but the movement in volatility will never be linear with respect to the
movement of the underlying portfolio of options that drive the index value.
The underlying principle of the new indices is discussed in the next section; a
more detailed derivation is available on request.
Km is the lowest strike price that is still higher than the forward price F. ∆K is the
difference between each strike price and for simplicity we assume that it is
constant.
The current value of a call can be calculated as the probability weighted average
of the call’s end of period value. Figure 3 illustrates the probability distribution
and the corresponding end of period values.
Suppose that out of a discrete set of end of period stock prices from 0 to some
large number, Sn, the highest discrete stock price that is less than F is Sg. Next,
suppose that the probability that the end of period stock price is Sg is pg. Then the
value of the j’th OTM call with strike price Kj, OTMCj, can be written as
(1) OTMCj = Σi=g+1 to n ρpi * Max(0, Si – Kj) where Kj > F, the futures price,
3
A few assumptions about the stock return distribution cannot, however, be avoided. The most
important may be the assumption that the distribution has a finite variance.
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Equity Derivatives & Quantitative Research
where ρ is the present value discount factor. This means that the call side of the
generalized straddle is
Figure 3: Estimating the Probability Weighted Value of the OTM 110 Call
50.0 2.5%
OTM Call
40.0 2.0%
Call Value at
Stock Prob
Probability
Expiration
110
30.0 1.5%
20.0 1.0%
10.0 0.5%
0.0 0.0%
0
0
0
50
70
90
60
80
10
11
12
13
14
15
Ending Stock Price
(2A) CallPortfolio = ΣFor all Kj>= Km (∆K / Kj2) {Σi=g+1 to n ρpi *Max(0, Si – Kj)}.
(2B) PutPortfolio = ΣFor all Kj < Km (∆K / Kj2) {Σi=1 to g ρpi *Max(0, Kj – Si)}.
The key step is reversing the order of summation in equations (2A) and (2B). This
changes the right hand side of each equation from a portfolio of options into an
expression that includes the expected log of the normalized end of period stock
price. The reason this is critical is that this expected log is linearly related to the
variance of the stock price.
To see that this is the case, first examine the equations after the order of
summation has been reversed:
(3A) CallPortfolio = Σi=g+1 to n ρpi *{ ΣFor all Kj>= Km (∆K / Kj2) *Max(0, Si – Kj)}.
(3B) PutPortfolio = Σi=1 to g ρpi * {ΣFor all Kj < Km (∆K / Kj2) *Max(0, Kj – Si)}.
GenSD = Σi=1 to n ρpi * {ΣFor all Kj>= Km (∆K / Kj2) *Max(0, Si – Kj)
+ ΣFor all Kj < Km (∆K / Kj2) *Max(0, Kj – Si) }.
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Equity Derivatives & Quantitative Research
S i /F – 1 - Log (S i /F).4
Σi=1 to n ρpi * { – Log (S i /F)} or, approximately, (-ρ) * Expected Log(S i /F).
That is the generalized straddle equals the negative of the discounted expected log
of the ending stock price normalized by the current futures price.
Here, Variance is the annualized variance of the stock price, T is the time to
expiration of the options (as a % of the year) and r is the annualized risk free rate.
In the case where the strike price, Km, does not equal the current futures price an
additional term is required and the relationship becomes,
4
There is another term that reflects the fact that Km does not exactly equal the futures price, F. The
value of this term can be approximated by ½ ρ (F / Km- 1)2
5
The expected value of the stock price, (approximately equal to Σi=1 to n pi * { S i }), equals the
futures price because by construction the probability distribution is “risk-neutral”. This causes the
first two terms in the summation to cancel out.
6
Tr - Log(F/S0) is close to zero. For example, if there are no dividends and there is a flat risk free
rate then, F = (1+r)T S0, making Log(F/S0) = Tlog(1+r). Since Tr is the first term of a Taylors
expansion for Log(1+r), Tlog(1+r) is close to Tr. The difference is of the order of the square of the
risk free rate.
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Equity Derivatives & Quantitative Research
Conclusion
Nonetheless, the implied variance estimated by the volatility index is not directly
investable. For example, it may seem natural simply to buy the options portfolio
that underlies the index. But one day after this portfolio is purchased, the options
experience time decay – even if the implied volatility does not drop. Moreover,
the options also have a delta and so the value of the options portfolio can rise and
fall with the market even if volatility levels do not change. If delta hedging is
introduced then realized volatility impacts the payoff. So the payoff to a product
that attempts to tie itself directly to an implied volatility index has a payoff that is
a hybrid of the changes in implied volatility and other factors such as market
movements or realized volatility combined with decay due to the passage of time.
The reason for this apparent paradox is that implied volatility is strictly a forward
looking concept. One day after it is estimated, implied volatility is “corrected” by
the actual volatility that occurs in the market place. Implied volatility can be
compared to the energy stored in a boulder at the top of a hill. Initially, all the
energy is potential (corresponding to implied volatility). Once the boulder starts
down the hill its energy changes from potential energy to kinetic energy (like
realized volatility). If there is no friction and no force is applied to the boulder
then the total energy level remains constant so that at the bottom of the hill the
total kinetic energy will be exactly equal to the initial potential energy. This
would correspond to the case where realized volatility was exactly what was
predicted by the implied volatility. But, in reality, a rolling boulder experiences
friction and other forces that affect its energy level so the translation from
potential energy to kinetic is not fully predictable and the total energy in the end
may differ substantially from the potential energy at the top of the hill. Similarly,
the realized volatility will differ from the implied.
Continuing with the analogy, it is not appropriate to estimate the total energy level
of a moving boulder by just calculating its potential energy. Similarly, it is not
appropriate to estimate the volatility of a stock index by looking only at implied
volatility once the index starts moving over time. The only time implied volatility
truly corresponds to the total volatility of the stock or stock index is before it
“starts moving”. That is to say, a product on implied volatility should be to be
forward looking, delivering the implied volatility as of some future date.
8
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12 months.
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