A new instrument called a gamma swap is being pitched and it's creating a buzz in the European markets. The swap plays realized variance against implied, like a variance swap, but the notional size of the trade increases or decreases in line with the underlying.
Deutsche Bank and BNP Paribas have priced trades, but officials say other firms, including SG Corporate & Investment Banking, are hot on their heels. Dealers said hedge funds trading equity volatility through variance swaps would likely be interested in the gamma deals, which they said can be used as a cleaner way of trading correlation. The gamma swap is the next step in the evolution of the variance swap, according to marketers pitching the deals.
In a typical variance swap, end users are playing the implied volatility of a single stock or index. In the variance swap, the move in the underlying stock or index at each day's close is taken into account when calculating the final payoff of the deal. In comparison, the aim of the gamma swap is to tie the notional size of the trade to the value of spot. So, if the value of the stock or index falls dramatically in a single day, with a gamma swap the notional size of the trade would also decrease.
One equity derivative sales official said although new products always pique hedge fund interest, even hedge funds have liquidity concerns when entering a trade only priced by two firms. But a hedge fund manager who had been pitched the deal told DW it is unlikely to be long before other shops start pricing the instruments because it is a simple progression on a variance swap, which most firms now trade actively. Variance swap trading has in fact been a big boom area for equity derivatives in recent years and it is even beginning to draw in institutional clients (DW, 12/10/04).
Jean-Michel Ritoux, an official in the new products group at BNP Paribas in Paris, said the firm is showing prices for gamma swaps linked to custom baskets of stocks. "[The gamma swap] is like a building block that can be used in lots of ways. The principle of it is very simple," he added. Equity correlation traders will also likely be interested in the instrument because its notional decreases in bearish markets--when correlation tends to move higher--and increases in bullish markets, when correlation tends to move lower, he explained. A trading official at Deutsche Bank confirmed it is marketing the trades to hedge fund clients. Officials at SG CIB said they have traded similar instruments, but declined further comment.
