Insurance companies have been buying back-end puts on U.S. equity indices to hedge variable annuities, while hedge funds have been selling front-end calls to exploit low realized volatility and low interest rates. The combination has driven implied volatility term structures steeper, and traders say the trend looks set to continue unless something dramatic drives up front end volatility.
Insurance companies--nontraditional players in this market--now have little choice but to buy back-end volatility, no matter how expensive it gets, traders said. They are responding to a National Association of Insurance Commissioners regulation requiring them to hedge exposure to equity-linked variable annuities. The statute, called C3 Phase 2, required insurance companies to hedge 20% of their annuities exposure by the end of 2005, 50% by 2006, 80% by 2007 and 90% by 2008. Insurance companies can hedge annuities either through specific reserves or by buying comparable maturity equity puts. Most are looking to buy puts, traders said, and even more will need to over the next three years. But a shortage of five- to 10-year option supply is bidding up the back end of the term structure. "Insurance companies are too big for the market right now," said one trader. "Everyone's one way and they're buying more than banks can sell."
Part of the problem, traders noted, is there are no natural sellers of long-dated volatility. "The closest thing is hedge funds selling two- to three-year vol through dispersion trades," said one trader.
