Bank of America is pitching volatility swaps to its clients because it expects Japanese equity market volatility to fall as the Nikkei plummets. The Nikkei fell below the Dow Jones Industrial Average last week, driving up implied volatility to its highest levels since the August 1998 Long-Term Capital Management crisis, according to Nick Waltner, managing director and head of equity financial products in Tokyo. As a result of the high vol, hedge funds and relative value players are looking at variance swaps to speculate on volatility falling.
"Funds will look to sell volatility through variance swaps above the 30% [implied volatility] level of the Nikkei for a one-year maturity" noted Alex Mayus, head of equity derivatives trading in Tokyo. He continued that implied volatility stands around 30% on the Nikkei while long-term realized historical volatility is closer to 20%. Clients benefit if realized vol is below the strike at the maturity of the swap, added Mayus. In a typical trade a U.S.-based hedge fund will enter a variance swap with a strike at 30% and a one-year to five-year maturity, predicting implied volatility will fall to 25% or lower. If this happens, the investor receives a pre-determined pay out, usually USD1-300,000, for each implied volatility point. All payments are made at the end of the transaction.