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Derivatives

Protected Vol Play Touted To The Masses

A handful of dealers including Citigroup, Deutsche Bank and JPMorgan are pricing capital-guaranteed calls on European equity variance and are pitching the structure to institutions and high-net-worth investors.

A handful of dealers including Citigroup, Deutsche Bank and JPMorgan are pricing capital-guaranteed calls on European equity variance and are pitching the structure to institutions and high-net-worth investors.

The call-option play is the first suggestion institutional investors and potentially even retail investors might buy into options on variance. "I think it's a good proposal," said one head of equity structuring at a rival firm in London.

Citi equity derivative strategists published a research report for clients last week with indicative payoffs for the structure, which would combine a zero-coupon bond and a call option on Euro STOXX 50 variance. In an example trade, an investor could purchase a EUR1 million capital guaranteed call option on variance to December 2009. At expiry, the investor would receive capital plus the return from the call option. If realized variance were to be at 25% between the investor buying the note and maturity, the investor would receive EUR1.33 million at expiry. Three-month realized variance was at about 10% Thursday.

A spate of variance-based investment structures has been launched over the last year, mostly by European firms. Dresdner Kleinwort has had some success marketing a relative-value play on implied volatility versus realized volatility to institutional clients such as insurance companies and asset managers (DW, 3/10). UBS and Merrill Lynch have offered certificates linked to volatility indices or straddles on equity indices.

The head of equity structuring at the rival firm said not every firm on the Street will be able to offer the structure, because variance options are not so liquid and the volatility of volatility is difficult to model. "At the same time realized volatility is so low right now it makes sense to think that variance is cheap," he added.

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