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Dealers Pitch VIX Lookalike Trades

Equity derivatives houses have begun structuring derivatives that give investors forward-starting exposure to the recently relaunchedChicago Board Options Exchange's Market Volatility Index (VIX). In practice, however, many firms are trading lookalike structures or exotic trades rather than plain-vanilla forwards referenced to the index itself.

The VIX is a measure of U.S. equity volatility. It references all non-zero listed options referenced to the Standard & Poor's 500. The problem for derivatives houses trading plain-vanilla forwards on the VIX is that if another S&P500 option is added to the exchange the VIX is recalculated. Until futures are launched on the VIX, which will be subject to the same calculations, the basis risk of the trades is difficult to manage.

JPMorgan has traded the first over-the-counter squared forward on the VIX. Adam Green, co-head of the investor marketing team and head of the private client marketing team for equity derivatives at JPMorgan in New York, explained that forwards on the VIX squared enable clients to gain exposure to the VIX in a relatively straightforward manner. The payoff for these transactions depends on the square of the VIX level less the square of the forward price on a selected date, he explained.

Leon Gross, global head of equity derivatives research at Citigroup Global Markets in New York, noted that when clients inquire about gaining forward exposure on the VIX the firm can offer something similar to the VIX with products such as forward-starting variance swaps and straddles. Until futures are launched on the VIX, however, a swap on the VIX itself would have a small unhedgable risk, which may affect its pricing or liquidity, he said.

The difference between the fair value of a one-month variance swap and the VIX is that the VIX only takes into account listed non-zero priced options, explained Gross. In the fair value of over-the-counter variance swaps the calculation includes all theoretical strikes past those that have prices in the listed market. This leaves the swap's fair value unaffected when more options on the S&P 500 are introduced because all possible option strikes have already been considered.

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