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Derivatives

Firms Push Variance Swaps As Vol Skyrockets

JPMorgan, Goldman Sachs and UBS Warburg have started aggressively marketing equity variance swaps--instruments that allow investors to gain exposure to changes in volatility--and some are pushing new versions as demand rockets on the back of high volatility. European equity volatility has spiked as high as 50% in recent weeks, which is higher than levels seen after Sept. 11, traders said. JPMorgan has seen a six-fold increase in demand for variance swaps in recent months and is now selling about 30 transactions a month, according to a firm official.

Investors typically buy variance swaps to take exposure to high implied volatility relative to realized vol. For example, an investor could sell a variance swap set at the current level of implied vol and if implied volatility falls, the investor receives a pre-determined payout for each volatility point. The technology to hedge these types of transactions is difficult to develop, which is one of the reasons firms have not offered these products en masse before. But high levels of volatility are spurring them to offer the product to investors since investors are willing to pay more to enter these trades, one trader explained.

JPMorgan is developing a certificate that can be sold to investors who cannot execute variance swaps because of regulatory reasons, such as some pension funds or insurance companies, according to the official. JPMorgan is also looking to offer single-stock variance swaps, although the majority of demand is still for index swaps, he noted.

Martin Boldt-Christmas, equity derivatives analyst at UBS Warburg in London, said recent marketing efforts have shown there is increased demand for these instruments from clients, such as hedge funds. He added that the U.S. has a more developed market, but that it is still growing in Europe. Therefore, margins are still reasonably wide, mostly because there is less liquidity in the options used to hedge the swaps, he explained. Goldman Sachs has started offering variance swaps in the past three months in Europe and plans to offer single-stock variance swaps in the near future as well, according to Altaf Kassam, associate in European equity derivatives and trading research in London. "We wanted to be absolutely sure we had the hedging technology in place before offering the product," he explained.

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