The latest twist on volatility instruments, known as a conditional variance swap, has started trading in size and is the focus of attention for both U.S. and European hedge funds and dealers. Only a handful of firms--including Goldman Sachs, SG Corporate & Investment Banking and BNP Paribas--are actively pricing the swaps. Others have been left scrambling to catch up before margins are squeezed out or fundamentals change and funds no longer want the instruments.
Citigroup has set up a group to look into offering the swaps and Credit Suisse is also hot on rivals' heels. In the swaps, a move is recorded only if a certain condition is met, such as spot being higher or lower than strike. The value of the swap is variable and proportional to the number of days the condition is met. The instruments were first pitched in embryo form about a year ago, according to hedge fund traders, but took off this year since funds hit on the idea of going long an up-var swap and short a down-var swap. This strategy enables funds to take a view on skew, the difference in implied volatilities of options with the same maturity but different strikes.
A salesman at a firm not offering the instruments said, "We have to get in there quick." Skew is affected by retail equity-linked issuance in Europe and Asia and the swaps offer opportunities for hedge funds to pick up on skew anomalies and for dealers to lay off skew risk. But the attraction is dissipating after a group of hedge funds jumped into the trade in the middle of January, he explained. An earlier incarnation of a skew trading instrument, known as a skew swap, failed to take off, but traders said the conditional var swap combination is clean and simple and doesn't require hedging from the fund, which makes it so attractive.
One fund manager said that because of difficulties for dealers in laying off exposure they may shortly reach risk limits, presenting an opportunity for other firms to catch up. However, a salesman at BNP disputed this, noting it's possible to replicate the swaps through an option portfolio, by buying upside strikes for the up-var swap and downside for the down-var swap. He predicted more and more exotic equity instruments will evolve this year as implied volatility looks set to remain at low levels, forcing volatility players into complex trades in order to find returns.
