Implementing Long Volatility Exposures for Hedging › rmc › 2016 › D2S5-James-Murray.pdf• Long Volatility exposures enable clients to run an appropriate target level of risk

Implementing Long Volatility Exposures for Hedging

1 December 2016

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• Risk Management.

• Spectrum of Downside Protection & Long Volatility Strategies.

• Long Volatility Strategies.

Agenda

Implementing Long Volatility Exposures for Hedging2

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Risk Management


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• Risk Management: risk is a multi-faceted, multi-horizon, concept that focuses on

the possibility of shortfall relative to expectations (journey) and outcomes

(destination). This definition of risk indicates a spectrum of potential sensitivities

across a range of time horizons rather than a single risk level (floor) for most

schemes.

• Objective: the objective of the Risk Management is broader than simply the

management of low frequency end of horizon events (mission impairment) and

accordingly extends from the left ‘shoulder’ of the distribution to the ‘tail’. Such a

wide envelope of risk management requires clarity around discrete investment

strategies and how such strategies intersect with the facets of risk.

Risk Management


Source: Willis Towers Watson, 2012 ‘The Wrong Type of Snow’.

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Reduce Deadweight Cost

• At times of stress, investors are often forced to incur deadweight costs to adjust the risk exposure of their portfolios. This rebalancing is accentuated for strategies with inflows insufficient to meet financing requirements (mature DB Portfolio).

• The deadweight adjustment first takes the form of reducing risks by liquidating the most liquid assets held to minimize transaction costs. By diminishing the supply of liquid assets early on, the deadweight adjustment costs are amplified if stress continues as the price of liquidity for these less liquid assets soars.

Maintain Risk Exposures

• Long Volatility exposures enable clients to run an appropriate target level of risk. Resilient Exposures enable the clients to have enough risk to generate wealth but not so much that mission is likely to be permanently impaired.

Mission Impairment

• The ‘Mission’ is the long term value creation proposition of the portfolio embodied within the investment objectives.

• Mission impairment is the risk that the portfolio’s end horizon objectives are not met and the Portfolio(s) does not survive the ‘journey’.

Objective of Long Volatility Risk Management Strategies


Note: Select text in this section taken from: Alankar, A; DePalama, M; & Scholes, M (2012) ‘An Introduction to Tail Risk Parity’, AllianceBernstein White Paper.

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We have spent significant time with our stakeholders clearly defining the

objectives of their Long Volatility approach.

Facets of Risk Management


Size Likelihood Impact Significance

Possible outcomes which fall below a threshold which ultimately comprises mission

The probability of the events associated with those outcomes.

Impact on the portfolio’s investment objectives.

An assessment of the impact of risk event on the portfolio’s mission including the effect of the stakeholder responses.

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Decomposing strategies by the facets of risk provides greater clarity for

clients allocating to defensive risk management strategies.

Delineating Risk Management Strategies


Source: TCorp.

Size (Equity Market Decline)Likelihood Impact Significance

6 Months 12 Months

Resilient Exposures -5% -10% Frequent Intra Horizon Moderate

Convex & Long Volatility Exposures -10% -20% Low Intra & End

Horizon High

TRH Expsoures -20% -25% Very Low End Horizon Impairment

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Spectrum of Downside Protection & Long Volatility Strategies


/ Implementing Long Volatility Exposures for Hedging

Spectrum of Downside Protection: Is the Problem Insufficient ‘Diversification’ or ‘Risk Management’?

MomentumLong Volatility Strategies

Tail Risk Hedging (TRH)

Incumbent: Strategic Asset Allocation with Dynamic Adjustments

• Risk defined as volatility.

• By equalising risk the strategy seeks to enhance diversification

• Risk forecasts are more reliable than return forecasts.

Volatility TargetingPortfolio Insurance

• Risk isn’t forecast volatility.

• Naïve versions assume ‘stationarity’ of correlation between “regime” assets.

• Incomplete nature of asset markets means not all regimes can be hedged.

• Leverage can transform a temporary impairment (i.e., price volatility) into a permanent impairment of capital.

Risk Parity

Inputs:

Volatility & CovarianceVolatility, Covariance & Return Drawdown / Pain Threshold Volatility

Definition:

Issues:


• Assets included based on positive expected return (risk premia).

• Trade off between assets determined by the portfolio’s aggregate risk and return preferences.

• Risk isn’t forecast volatility.

• High real return targets may mean that portfolios are less diversified as clients trade return for diversification.

• The cost of the crisis and subsequent fiscal and monetary methadone has been reduced diversity.

• Optimisation of portfolio sensitive to inputs.

• DAA information ratio low.

• Risk defined as absolute drawdown.

• Convex strategies seek to perform in environments where client’s market portfolio of growth exposures underperform.

• Pattern of returns more important than equilibrium assumptions of return.

• Low returns (in normal environments) create significant opportunity costs.

• Allocation to strategies needs to be meaningful to have impact.

• Given the dependence on skill (persistent negative correlation & low theta) such strategies are rare, non-scalable and (if located) expensive.

• Risk defined as absolute drawdown

• Hedge catastrophic loss through use of options.

• TRH may be judgmental or deterministic.

• Clear transparent hedge.

• Significant explicit cost creates behavioural challenges.

• Implementation hurdles when executed in size or over short horizons.

• Risk defined as outcome below a dollar value (predefined floor).

• Dynamically creates a cash cushion using futures to offset large market losses.

• The level at which risk exposure is curtailed is independent of volatility.

• Portfolio Insurance is path dependent. For the same past returns, risk asset allocation can vary depending on distance of asset value from floor.

• Crystallisation of losses provides no opportunity to recover. Portfolio Insurance may bring forward ‘mission impairment’.

• Weak protection in sharp drawdowns (c.1987).


• Volatility (spot or term structure) used to modulate the absolute level of risk.

• Volatility markets have informational content and are seen as a leading indicator of returns.

• Risk isn’t observed volatility (spot or term structure).

• Targeting volatility may lead to smoothing returns but may not limit drawdown.

• Volatility does not always correctly predict drawdowns (‘rational volatility markets’ / ‘irrational equity markets’) and provides a number of false positives.

• Strategies decompose price series into ‘trend’ and ‘noise’ and seek to capture ‘trends’.

• Observed positive skew.

• Empirically strategy is similar to a straddle (a call and a put), and hence offers exposure to rising market volatility.

• Momentum strategies are vulnerable to a counter-trend shock.

• Contracting volatility and range bound environments are not conducive to Momentum strategies.

Designed to Address:

Insufficient Diversification- Incomplete Risk ManagementInsufficient Diversification &

Incomplete Risk Management

Dynamic Beta ModulationDiversification Asymmetric / Convex

Stock Replacement

• Targets a linear return with high equity beta.

• Replace outright long exposures with Delta and Vega positions.

• Complex asset allocation problem – how do we manage within the context of the asset allocation?

• Strategy is the inverse of buy-write premium – and despite high skew may provide a meaningful drag to portfolio returns.

Volatility / Skew

Asymmetric Risk Substitution

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Long Volatility Strategies


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Implementing Long Volatility Exposures

• Optimisation Process: trade-off between Convexity, Basis (Timing), Basis (Assets the

client is seeking to hedge) and Cost (Theta / Bleed). There is no free lunch.

• Basis Can’t Be Removed: the absence of ‘Arrow’ securities and market incompleteness

(e.g., Australia) require the assumption of tracking error within the Long Volatility portfolio.

• Long Volatility Strategies Exists as Portfolio Management Tool: requirement to frame

the strategies within the context of broader asset allocation.

For Official Use OnlyImplementing Long Volatility Exposures for Hedging11

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Implementing Long Volatility Exposures: Manager Strategies

Long Volatility as a Defensive / Fixed Income Substitute

• The cost of the crisis has been reduced diversification.

• Fixed income is no longer the ‘anchor to the windward’: bonds at low yields offer

reduced potential positive skew at the portfolio level (with bonds bound by the cash-and-

carry constraint). Further, as noted by Fisher Black (‘Interest Rates as Options’, 1995)

bonds at low yields become short volatility instruments.

Challenges in Implementing Long Volatility Manager Strategies

• Objective Clarity: significant diffused industry definitions: What are we seeking to hedge?

What does success/failure look like? What is the difference between the ‘tail’ and the

‘shoulder’? Who is responsible for monetization?

• Shallow Bench: relative few managers with appropriate resources.

• Business Model: long volatility is a challenging business model.


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Heterogenous Investment Strategies


Closest peer

group

Benchmark (if

applicable)

Reference

Underlying

Risk-on /

bullish markets

Normal

Environment

Shallow Crisis

[e.g. Equities

down 10-20%

and implied

volatility up 10-

20pts]

Severe Crisis

[e.g. Equities

down 20-50%

and implied

volatility up

20pts++]

Strategy ACBOE Long

Volatility IndicesNone. US Equity. +3% 9% 15% 35-50%

Strategy BRelative Value

Funds

HFRX Relative

Value Arbitrage

Index

US Equity -3% to +5% +5% to 15% +10% to +20% -5% to +20%

Strategy C None. None,Global cross

asset-1.5% to +15% -8% to 0% +3% to 21% +30% to 85%

Strategy D None. None.Global cross

asset-5% to +50% -25% to 0% +10% to +70% +100% to +280%

Strategy ECBOE Long

Volatility IndicesNone Global Equity. -6% to -4% +3 to +7% +7% to +10% >10%

Strategy F

CBOE Long

Volatility IndicesNone Euro Equity -6% to -4% +3 to +7% +7% to +10% >10%

Strategy GCBOE Long

Volatility Indices

CBOE S&P 500

95-110 Collar

Index - minus

S&P 500

US Equity. -13% +11% +27% +99%

Strategy HCBOE Long

Volatility Indices

CBOE Long

Volatility IndicesUS Equity -10% to 0% -2% to +10% "+5% to +50% +50% to 200%

Strategy ICBOE Long

Volatility Indices

SG Volatility

Trading IndexUS Equity. -2% to -4% -2% to 0% +10% to +30% +35%

‘CBOE Long Volatility Index’: Not Apples for Apples.

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Heterogenous Volatility Investors & Markets

LONG TERM NIKKEI KOSPI HSCEI SX5E S&P500 AS51

Main DriverStructured Products

(Uradashi)

Structured Products

(Autocallables) and

variance swaps

Structured Products

(Autocallables) and

variance swaps

Structured Products VIX ETNs / ETFsBuy-Write, Income

Funds & TRH (Pension)

Parameter Volatility & Skew Volatility & Skew Skew and Volatility LT Skew Term Structure (VIX) Skew

Expected Impact

Volatility & Skew ↓

under flow of new

issuance.

Volatility & Skew ↓

under flow of new

issuance. Demand of

volatility from relative

value variance swap

players is mitigated by

autocallable flow.

Autocallables put

pressure on skew.

Volatility is high from

demand by relative

value players buying

HSCEI volatility to sell

SPX volatility.

Subject to spot

direction.

(i) range bound =↓ skew

(ii) rally = ↑ skew

Prolonged contango on

VIX Futures.

No supply of LT

volatility. Volatility

whipsawed by pension

demand. Demand of

upside volatility from

global baskets and

insurance/pensions.

SHORT TERM NIKKEI KOSPI HSCEI SX5E S&P500 AS51

Main Driver

Options Flow -- for the

past 2 years always

upside.

Short term variance

swaps and flow

Flow, always on the

upside (Warrants)Flow

Protection purchases

and VIX flow

Buy-Write (Index &

Single Stock)

Parameter Volatility & Skew Volatility Skew and Volatility Volatility Term Structure (VIX) Skew

Expected Impact

Skew in demand when

volatility is high. Clients

buy call spreads to

reduce the premium

cost, skew is low when

vol is low as clients buy

straight calls or

protection

Systematic variance

swap sellers looking for

yield as the realized is

low are pushing skew

and volatility lower.

Very much momentum

based.

Warrant flow is a driver

of volatility on any move

higher.

Skew moves as a

function of the market

dynamic. In bullish

markets skew can go

close to flat.

SX5E is a trade and not

an investment for most

accounts, so carry tends

to be an overriding

concern.

SPX flows are always

skewed towards buying

downside as it’s the

world's preferred

hedging instrument, and

that’s why implied are

always over realized

vols. VIX options flows

(buying calls) and the

VXX ETN product has

also lead to steeper

skew.

There are 2 opposing

forces with protection

buyers pushing the

skew higher, while

AS51 was for a long

time the standard short

variance leg from

relative value players.

Volatility markets are complex requiring significant resourcing to construct global portfolios.

Source: Societe Generale, Citi, UBS, TCorp.


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Implementing Long Volatility Exposures: Systematic Strategies

• Systematic strategies: Investment Banks and Managers have a range of systematic

strategies to capture convexity without the high carry cost of parsimonious long volatility

strategies.

• Lucas Critique: systematic long volatility products are optimized on the past and are

highly susceptible to regime shifts. The Lucas Critique states that “once statistical

properties become detectable – they become self cancelling”.


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Conclusion


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Implementing Long Volatility Exposures

• Requirement for Long Volatility: the cost of the crisis has been reduced diversification.

• Objective of Long Volatility Strategies: we recommend that schemes invest in clearly

defining the objectives of their Long Volatility approach.

• Spectrum of Downside Protection & Long Volatility: we view Long Volatility strategies

as part of the spectrum of downside protection strategies.

• Portfolio Construction Approach: we recommend a portfolio construction approach

which trades-off: Convexity, Basis (Timing), Basis (Assets the client is seeking to hedge)

and Cost (Theta / Bleed).

• Manager Strategies: display significant heterogeneity and can not easily be blended.

• Systematic Strategies: are prone to ‘fighting the last war’


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Appendix


These slides are not to

be included in the

handouts/web-app or

on the web post the

conference.

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Significant, prolonged market turmoil. Macro Hedge is long only (defensive). Strong Macro Hedge Index performance from long vol exposure

Macro Hedge: Regime 1 - Prolonged Market Sell-Off

JP Morgan Macro Hedge (JPMZMHUT Index) & J.P. Morgan Macro Hedge

Enhanced VT 4% (JPMZVTE4 Index)

Source: JP Morgan.


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Typically strong equity performance and strong JP Morgan Macro Hedge performance. Stable volatility allows monetization of term structure roll down

Macro Hedge: Regime 2 - Stable Market Volatility



Source: JP Morgan.


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Variable JP Morgan Macro Hedge Signal, poor performance from long volatility

exposure and volatility quickly collapsing after initial spike.

Macro Hedge: Regime 3 - High Vol-of-Vol + No Event



Source: JP Morgan.


Documents

Implementing Long Volatility Exposures for Hedging › rmc › 2016 › D2S5-James-Murray.pdf• Long Volatility exposures enable clients to run an appropriate target level of risk