The growing popularity of equity index variance swaps traded with an embedded volatility cap is fostering a market for options on equity volatility, according to exotic equity traders in London. Variance swaps are often traded by hedge funds in so-called dispersion trades, in which funds take a view on the correlation between the volatility of an equity index and the volatility of its stock components.
Prime brokers are encouraging counterparties to execute variance swaps with caps and this is driving the market for options on volatility, according to traders. Traders estimate that around 40% of dispersion trades now have a cap on the index leg. The caps can be one of three types: a fixed strike of 50% of the index volatility; a fixed spread above the index volatility; or two-and-a half-times the index vol. "This [pricing of caps] is evolving into the trading of options on volatility," said Richard Carson, head of exotic products trading at Deutsche Bank in London. Traders reported that the more sophisticated hedge funds are looking at variance swaps with caps closer to the strike of the variance swap, for example at 20% of the index volatility. "This could be difficult to risk manage," warned one equity derivatives analyst.
Contracts on forward equity volatility were traded earlier this year by UBS and Merrill Lynch (DW, 3/7) and marketed to portfolio managers. Options on volatility could also be of interest to fund managers, said officials.
