Hedge funds have been snapping up short-dated index volatility and selling long-dated vol to profit from a sudden steepening of term structure. Five-year Euro STOXX 50 implied volatility was trading at 18% last week, while one-month was at 11%. Dealers said long-dated vol has spiked because of perceived market risks, such as the upset in credit derivative markets, and has not eased as much as short-dated vol, which seems to be less sensitive (DW, 5/20).
One volatility trader said, "It's an attractive trade right now." But, he noted the term structure is driven by market flows at the moment, which are against the hedge funds' positions. Institutional flow tends to buy long-dated options and sell shorter dates and this is supporting the steep term structure. "I'm not sure they'll make any money on this one," concluded the trader.