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Implementing Long Volatility Exposures for Hedging
1 December 2016
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• Risk Management.
• Spectrum of Downside Protection & Long Volatility Strategies.
• Long Volatility Strategies.
Agenda
Implementing Long Volatility Exposures for Hedging2
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Risk Management
Implementing Long Volatility Exposures for Hedging3
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• Risk Management: risk is a multi-faceted, multi-horizon, concept that focuses on
the possibility of shortfall relative to expectations (journey) and outcomes
(destination). This definition of risk indicates a spectrum of potential sensitivities
across a range of time horizons rather than a single risk level (floor) for most
schemes.
• Objective: the objective of the Risk Management is broader than simply the
management of low frequency end of horizon events (mission impairment) and
accordingly extends from the left ‘shoulder’ of the distribution to the ‘tail’. Such a
wide envelope of risk management requires clarity around discrete investment
strategies and how such strategies intersect with the facets of risk.
Risk Management
Implementing Long Volatility Exposures for Hedging4
Source: Willis Towers Watson, 2012 ‘The Wrong Type of Snow’.
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Reduce Deadweight Cost
• At times of stress, investors are often forced to incur deadweight costs to adjust the risk exposure of their portfolios. This rebalancing is accentuated for strategies with inflows insufficient to meet financing requirements (mature DB Portfolio).
• The deadweight adjustment first takes the form of reducing risks by liquidating the most liquid assets held to minimize transaction costs. By diminishing the supply of liquid assets early on, the deadweight adjustment costs are amplified if stress continues as the price of liquidity for these less liquid assets soars.
Maintain Risk Exposures
• Long Volatility exposures enable clients to run an appropriate target level of risk. Resilient Exposures enable the clients to have enough risk to generate wealth but not so much that mission is likely to be permanently impaired.
Mission Impairment
• The ‘Mission’ is the long term value creation proposition of the portfolio embodied within the investment objectives.
• Mission impairment is the risk that the portfolio’s end horizon objectives are not met and the Portfolio(s) does not survive the ‘journey’.
Objective of Long Volatility Risk Management Strategies
Implementing Long Volatility Exposures for Hedging5
Note: Select text in this section taken from: Alankar, A; DePalama, M; & Scholes, M (2012) ‘An Introduction to Tail Risk Parity’, AllianceBernstein White Paper.
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We have spent significant time with our stakeholders clearly defining the
objectives of their Long Volatility approach.
Facets of Risk Management
Implementing Long Volatility Exposures for Hedging6
Size Likelihood Impact Significance
Possible outcomes which fall below a threshold which ultimately comprises mission
The probability of the events associated with those outcomes.
Impact on the portfolio’s investment objectives.
An assessment of the impact of risk event on the portfolio’s mission including the effect of the stakeholder responses.
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Decomposing strategies by the facets of risk provides greater clarity for
clients allocating to defensive risk management strategies.
Delineating Risk Management Strategies
Implementing Long Volatility Exposures for Hedging7
Source: TCorp.
Size (Equity Market Decline)Likelihood Impact Significance
6 Months 12 Months
Resilient Exposures -5% -10% Frequent Intra Horizon Moderate
Convex & Long Volatility Exposures -10% -20% Low Intra & End
Horizon High
TRH Expsoures -20% -25% Very Low End Horizon Impairment
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Spectrum of Downside Protection & Long Volatility Strategies
Implementing Long Volatility Exposures for Hedging8
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Spectrum of Downside Protection: Is the Problem Insufficient ‘Diversification’ or ‘Risk Management’?
MomentumLong Volatility Strategies
Tail Risk Hedging (TRH)
Incumbent: Strategic Asset Allocation with Dynamic Adjustments
• Risk defined as volatility.
• By equalising risk the strategy seeks to enhance diversification
• Risk forecasts are more reliable than return forecasts.
Volatility TargetingPortfolio Insurance
• Risk isn’t forecast volatility.
• Naïve versions assume ‘stationarity’ of correlation between “regime” assets.
• Incomplete nature of asset markets means not all regimes can be hedged.
• Leverage can transform a temporary impairment (i.e., price volatility) into a permanent impairment of capital.
Risk Parity
Inputs:
Volatility & CovarianceVolatility, Covariance & Return Drawdown / Pain Threshold Volatility
Definition:
Issues:
• Risk defined as volatility.
• Assets included based on positive expected return (risk premia).
• Trade off between assets determined by the portfolio’s aggregate risk and return preferences.
• Risk isn’t forecast volatility.
• High real return targets may mean that portfolios are less diversified as clients trade return for diversification.
• The cost of the crisis and subsequent fiscal and monetary methadone has been reduced diversity.
• Optimisation of portfolio sensitive to inputs.
• DAA information ratio low.
• Risk defined as absolute drawdown.
• Convex strategies seek to perform in environments where client’s market portfolio of growth exposures underperform.
• Pattern of returns more important than equilibrium assumptions of return.
• Low returns (in normal environments) create significant opportunity costs.
• Allocation to strategies needs to be meaningful to have impact.
• Given the dependence on skill (persistent negative correlation & low theta) such strategies are rare, non-scalable and (if located) expensive.
• Risk defined as absolute drawdown
• Hedge catastrophic loss through use of options.
• TRH may be judgmental or deterministic.
• Clear transparent hedge.
• Significant explicit cost creates behavioural challenges.
• Implementation hurdles when executed in size or over short horizons.
• Risk defined as outcome below a dollar value (predefined floor).
• Dynamically creates a cash cushion using futures to offset large market losses.
• The level at which risk exposure is curtailed is independent of volatility.
• Portfolio Insurance is path dependent. For the same past returns, risk asset allocation can vary depending on distance of asset value from floor.
• Crystallisation of losses provides no opportunity to recover. Portfolio Insurance may bring forward ‘mission impairment’.
• Weak protection in sharp drawdowns (c.1987).
• Risk defined as volatility.
• Volatility (spot or term structure) used to modulate the absolute level of risk.
• Volatility markets have informational content and are seen as a leading indicator of returns.
• Risk isn’t observed volatility (spot or term structure).
• Targeting volatility may lead to smoothing returns but may not limit drawdown.
• Volatility does not always correctly predict drawdowns (‘rational volatility markets’ / ‘irrational equity markets’) and provides a number of false positives.
• Strategies decompose price series into ‘trend’ and ‘noise’ and seek to capture ‘trends’.
• Observed positive skew.
• Empirically strategy is similar to a straddle (a call and a put), and hence offers exposure to rising market volatility.
• Momentum strategies are vulnerable to a counter-trend shock.
• Contracting volatility and range bound environments are not conducive to Momentum strategies.
Designed to Address:
Insufficient Diversification- Incomplete Risk ManagementInsufficient Diversification &
Incomplete Risk Management
Dynamic Beta ModulationDiversification Asymmetric / Convex
Stock Replacement
• Targets a linear return with high equity beta.
• Replace outright long exposures with Delta and Vega positions.
• Complex asset allocation problem – how do we manage within the context of the asset allocation?
• Strategy is the inverse of buy-write premium – and despite high skew may provide a meaningful drag to portfolio returns.
Volatility / Skew
Asymmetric Risk Substitution
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Long Volatility Strategies
Implementing Long Volatility Exposures for Hedging10
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Implementing Long Volatility Exposures
• Optimisation Process: trade-off between Convexity, Basis (Timing), Basis (Assets the
client is seeking to hedge) and Cost (Theta / Bleed). There is no free lunch.
• Basis Can’t Be Removed: the absence of ‘Arrow’ securities and market incompleteness
(e.g., Australia) require the assumption of tracking error within the Long Volatility portfolio.
• Long Volatility Strategies Exists as Portfolio Management Tool: requirement to frame
the strategies within the context of broader asset allocation.
For Official Use OnlyImplementing Long Volatility Exposures for Hedging11
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Implementing Long Volatility Exposures: Manager Strategies
Long Volatility as a Defensive / Fixed Income Substitute
• The cost of the crisis has been reduced diversification.
• Fixed income is no longer the ‘anchor to the windward’: bonds at low yields offer
reduced potential positive skew at the portfolio level (with bonds bound by the cash-and-
carry constraint). Further, as noted by Fisher Black (‘Interest Rates as Options’, 1995)
bonds at low yields become short volatility instruments.
Challenges in Implementing Long Volatility Manager Strategies
• Objective Clarity: significant diffused industry definitions: What are we seeking to hedge?
What does success/failure look like? What is the difference between the ‘tail’ and the
‘shoulder’? Who is responsible for monetization?
• Shallow Bench: relative few managers with appropriate resources.
• Business Model: long volatility is a challenging business model.
For Official Use OnlyImplementing Long Volatility Exposures for Hedging12
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Heterogenous Investment Strategies
Implementing Long Volatility Exposures for Hedging13
Closest peer
group
Benchmark (if
applicable)
Reference
Underlying
Risk-on /
bullish markets
Normal
Environment
Shallow Crisis
[e.g. Equities
down 10-20%
and implied
volatility up 10-
20pts]
Severe Crisis
[e.g. Equities
down 20-50%
and implied
volatility up
20pts++]
Strategy ACBOE Long
Volatility IndicesNone. US Equity. +3% 9% 15% 35-50%
Strategy BRelative Value
Funds
HFRX Relative
Value Arbitrage
Index
US Equity -3% to +5% +5% to 15% +10% to +20% -5% to +20%
Strategy C None. None,Global cross
asset-1.5% to +15% -8% to 0% +3% to 21% +30% to 85%
Strategy D None. None.Global cross
asset-5% to +50% -25% to 0% +10% to +70% +100% to +280%
Strategy ECBOE Long
Volatility IndicesNone Global Equity. -6% to -4% +3 to +7% +7% to +10% >10%
Strategy F
CBOE Long
Volatility IndicesNone Euro Equity -6% to -4% +3 to +7% +7% to +10% >10%
Strategy GCBOE Long
Volatility Indices
CBOE S&P 500
95-110 Collar
Index - minus
S&P 500
US Equity. -13% +11% +27% +99%
Strategy HCBOE Long
Volatility Indices
CBOE Long
Volatility IndicesUS Equity -10% to 0% -2% to +10% "+5% to +50% +50% to 200%
Strategy ICBOE Long
Volatility Indices
SG Volatility
Trading IndexUS Equity. -2% to -4% -2% to 0% +10% to +30% +35%
‘CBOE Long Volatility Index’: Not Apples for Apples.
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Heterogenous Volatility Investors & Markets
LONG TERM NIKKEI KOSPI HSCEI SX5E S&P500 AS51
Main DriverStructured Products
(Uradashi)
Structured Products
(Autocallables) and
variance swaps
Structured Products
(Autocallables) and
variance swaps
Structured Products VIX ETNs / ETFsBuy-Write, Income
Funds & TRH (Pension)
Parameter Volatility & Skew Volatility & Skew Skew and Volatility LT Skew Term Structure (VIX) Skew
Expected Impact
Volatility & Skew ↓
under flow of new
issuance.
Volatility & Skew ↓
under flow of new
issuance. Demand of
volatility from relative
value variance swap
players is mitigated by
autocallable flow.
Autocallables put
pressure on skew.
Volatility is high from
demand by relative
value players buying
HSCEI volatility to sell
SPX volatility.
Subject to spot
direction.
(i) range bound =↓ skew
(ii) rally = ↑ skew
Prolonged contango on
VIX Futures.
No supply of LT
volatility. Volatility
whipsawed by pension
demand. Demand of
upside volatility from
global baskets and
insurance/pensions.
SHORT TERM NIKKEI KOSPI HSCEI SX5E S&P500 AS51
Main Driver
Options Flow -- for the
past 2 years always
upside.
Short term variance
swaps and flow
Flow, always on the
upside (Warrants)Flow
Protection purchases
and VIX flow
Buy-Write (Index &
Single Stock)
Parameter Volatility & Skew Volatility Skew and Volatility Volatility Term Structure (VIX) Skew
Expected Impact
Skew in demand when
volatility is high. Clients
buy call spreads to
reduce the premium
cost, skew is low when
vol is low as clients buy
straight calls or
protection
Systematic variance
swap sellers looking for
yield as the realized is
low are pushing skew
and volatility lower.
Very much momentum
based.
Warrant flow is a driver
of volatility on any move
higher.
Skew moves as a
function of the market
dynamic. In bullish
markets skew can go
close to flat.
SX5E is a trade and not
an investment for most
accounts, so carry tends
to be an overriding
concern.
SPX flows are always
skewed towards buying
downside as it’s the
world's preferred
hedging instrument, and
that’s why implied are
always over realized
vols. VIX options flows
(buying calls) and the
VXX ETN product has
also lead to steeper
skew.
There are 2 opposing
forces with protection
buyers pushing the
skew higher, while
AS51 was for a long
time the standard short
variance leg from
relative value players.
Volatility markets are complex requiring significant resourcing to construct global portfolios.
Source: Societe Generale, Citi, UBS, TCorp.
Implementing Long Volatility Exposures for Hedging14
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Implementing Long Volatility Exposures: Systematic Strategies
• Systematic strategies: Investment Banks and Managers have a range of systematic
strategies to capture convexity without the high carry cost of parsimonious long volatility
strategies.
• Lucas Critique: systematic long volatility products are optimized on the past and are
highly susceptible to regime shifts. The Lucas Critique states that “once statistical
properties become detectable – they become self cancelling”.
For Official Use OnlyImplementing Long Volatility Exposures for Hedging15
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Conclusion
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Implementing Long Volatility Exposures
• Requirement for Long Volatility: the cost of the crisis has been reduced diversification.
• Objective of Long Volatility Strategies: we recommend that schemes invest in clearly
defining the objectives of their Long Volatility approach.
• Spectrum of Downside Protection & Long Volatility: we view Long Volatility strategies
as part of the spectrum of downside protection strategies.
• Portfolio Construction Approach: we recommend a portfolio construction approach
which trades-off: Convexity, Basis (Timing), Basis (Assets the client is seeking to hedge)
and Cost (Theta / Bleed).
• Manager Strategies: display significant heterogeneity and can not easily be blended.
• Systematic Strategies: are prone to ‘fighting the last war’
For Official Use OnlyImplementing Long Volatility Exposures for Hedging17
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Appendix
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These slides are not to
be included in the
handouts/web-app or
on the web post the
conference.
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Significant, prolonged market turmoil. Macro Hedge is long only (defensive). Strong Macro Hedge Index performance from long vol exposure
Macro Hedge: Regime 1 - Prolonged Market Sell-Off
JP Morgan Macro Hedge (JPMZMHUT Index) & J.P. Morgan Macro Hedge
Enhanced VT 4% (JPMZVTE4 Index)
Source: JP Morgan.
Implementing Long Volatility Exposures for Hedging19
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Typically strong equity performance and strong JP Morgan Macro Hedge performance. Stable volatility allows monetization of term structure roll down
Macro Hedge: Regime 2 - Stable Market Volatility
JP Morgan Macro Hedge (JPMZMHUT Index) & J.P. Morgan Macro Hedge
Enhanced VT 4% (JPMZVTE4 Index)
Source: JP Morgan.
Implementing Long Volatility Exposures for Hedging20
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Variable JP Morgan Macro Hedge Signal, poor performance from long volatility
exposure and volatility quickly collapsing after initial spike.
Macro Hedge: Regime 3 - High Vol-of-Vol + No Event
JP Morgan Macro Hedge (JPMZMHUT Index) & J.P. Morgan Macro Hedge
Enhanced VT 4% (JPMZVTE4 Index)
Source: JP Morgan.
Implementing Long Volatility Exposures for Hedging21
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