Buying and selling options on variance has started in earnest, as the volatility environment is less certain and the instruments are becoming more widely traded. The structures, first traded just over a year ago (DW, 10/1/04) pay out the difference between the strike and the realized variance on a variance swap of the same maturity and size as the option. More trading also means the premiums for these exotic options are coming down, which makes them more attractive to buyers.
Gerry Fowler, equity derivatives strategist at Citigroup in London, said there has been two-way interest, piqued by Euro STOXX 50 volatility climbing to about 14-15% after dropping off to a low of 10% in the last few weeks. Some funds which have benefited from being short variance over the last two years are now setting up as short variance funds and Fowler said they have been buying call options on variance. Buying the option is effectively a hedge for a jump in volatility and the cost of the hedge is limited to the option premium. One flow salesman said the strategy is being looked at by banks which have structured investment products using constant proportion portfolio insurance. CPPI risks locking assets in to low-yielding investments if there is a sudden jump in volatility.
