Provisional Title

8/6/2019 Provisional Title

1/57

Dissertation in Part Fulfillment of MBA

FINANCE (UWIC)

Is there a case to be made for trading

Volatility as an asset class?

Elkanah Ondieki Oenga ST10007121


2/57

2 | P a g e

Acknowledgement

The magnitude of support I have received during the journey of producing this piece of

work.

The likelihood of forgetting some who have been instrumental in this journey is enormous

and for those forgotten I apologise.

God has been kind during this period , he has bestowed health and providence along the way

and for this I am grateful always.

My Parents for their never ending support.

David Snell my supervisor who has been instrumental in modelling in me a research student.

He went above the norm of what is expected in a supervisor-student relationship, he

became a pillar of support and encouragement and for this I am greatly indebted.

My fellow students going through this process at the same time for their never ending input,

especially one Julie. Thank you.

Lastly I would like to thank the management and administrators of the MBA course at LSC

for their commitment in the provision of quality education.

Thank you all.


3/57

3 | P a g e

Abstract

This dissertation looks at the status of volatility as an asset class.

Volatility as an asset class is to be viewed under the lenses of asset class features and

definition against the backdrop of another asset class i.e. infrastructure.

Much debate about the status of volatility assets classing into a class of their own has b een

raging in the recent past. This is measured against the background of advances in the field of

financial assets.

The researcher looks at the inherent features of asset classes and why this features control

the status pinned on them.

Volatility assets are a game changer in the financial industry being the only asset class with a

negative correlation with other traditional assets.


4/57

4 | P a g e

Introduction

The history and progression of volatility assets to the level they are being traded today and

the reasons for certain industry decisions which are detrimental or positive in their effect

towards the trading of volatility assets as an asset class.

The measure of volatility and the factors influencing volatility trading against similar

conditions in the tra de of infrastructure class of assets.

With the ever increasing volatility products and trade in volatility the need to understand

the origin and status of such assets is becoming an ever increasing need for the average

investor.

Almost all financial literature takes the view that variance cannot be observed. This is no

longer held true with the advent of new products that enable the investor invest in volatility

There is also the continued increase of volatility indexes like the VIX index which is based on

the 500 etc.


5/57

5 | P a g e

Table of Contents

Literature Review ................................ ................................ ................................ .................. 7

What is Volatility? Towards a definition: ................................ ................................ ............... 9

A Bit of History, towards showing progression ................................ ................................ 11

What are the features of volatility? Towards a mental image ................................ .......... 13

What is VIX? Towards an Understanding ................................ ................................ ......... 14

What are the ways of investing in volatility? Towards understanding HOW .................... 16

Infrastructure as an asset class ................................ ................................ ........................... 17

Characteristics of Infrastructure as an asset class ................................ ............................ 18

What forms do investments in Infrastructure take? ................................ ........................ 19

What is an asset class? Towards a setting a benchmark................................ ................... 20

Inference from literature review (conclusion) ................................ ................................ . 21

Research Methodology ................................ ................................ ................................ ....... 24

Introduction ................................ ................................ ................................ .................... 24

Research Problem and Questions ................................ ................................ .................... 24

Justification of paradigm and methodology ................................ ................................ ..... 25

Research Design ................................ ................................ ................................ .............. 26

Research strategies ................................ ................................ ................................ ......... 27

Literature Review................................ ................................ ................................ ......... 28

Interviews ................................ ................................ ................................ .................... 28

Data ................................ ................................ ................................ ................................ 29

Instrumentation ................................ ................................ ................................ ........... 31

Analysis of Data ................................ ................................ ................................ ........... 33

Validity and Reliability................................ ................................ ................................ .. 34

Triangulation ................................ ................................ ................................ ............... 35

Data collection ................................ ................................ ................................ ............. 35


6/57

6 | P a g e

Findings, Analysis and Discussion ................................ ................................ ........................ 38

Findings ................................ ................................ ................ Error! Bookmark not defined.

The Interviewees ................................ ................................ ................................ ............. 40

Data Analysis from Interviews ................................ ................................ ......................... 41

Volatility trading perceptions and Aetiology ................................ ................................ 41

Analysis and Discussion ........................... ..... ........................ Error! Bookmark not defined.

Ethical Considerations ................................ ................................ ................................ ..... 48

Conclusion and Recommendation ................................ ................................ ....................... 48

Work Plan ................................ ................................ ................................ ........................... 53

Bibliography ................................ ................................ ................................ ........................ 54


7/57

7 | P a g e

Literature Review

In recent times, institutional and private investors have shown an increased interest in

volatility as an investment vehicle. At first sight, investing in volatility appears attractive

since volatility movements are known to be negatively correlated with stock index returns.

Thus, adding volatility exposure to a portfolio of common stocks promises to improve risk

diversification. In addition, past experience indicates that negative correlation is particularly

pronounced in stock market downturns, offering protection against stock market losses

when it is needed most (Hafner & Wallmeier, 2005).

How investment returns compare in terms of variation or expected variation from a set

average over a period of time. This is what is termed as volatility. The standard measure of

realised returns is a common measure of volatility where the returns are assumed to have

normal distribution.

Volatility is a form of risk that most investors dislike, so they will p ay somebody else to take

that risk off their hands for the same reason people buy fire insurance on their house. To

the extent that one takes a consistently short position on volatility, they will earn a premium

every period but sustain big losses occasionally (as was the case in parts of 2008), just like

an insurer paying out a claim. This is the basis of the higher returns obtained by many hedge

funds, not any clear advantage of skill. Taking the argument of those who see volatility as an

asset class to an extreme, owning an insurance company does not serve the intended

purpose as it carries its own risk.

There is general disagreement on the adequate amount of volatility exposure that may be

deemed to be positive. There are two possible scenarios the firs t one is where there is very

little volatility exposure and the risk -return does not compensate adequately for risk

undertaken. The second scenario is where volatility is extremely high leading to falling asset

values and Government has to readjust policy (J. P. Morgan Securities Limited, 2008) .

In order to make an assessment of future returns from active (alpha) and passive (beta) risk

there is need to predict volatility. This is also useful in assessing the kind of policies

Governments need to pass (Ibid).


8/57

8 | P a g e

Houses are an asset, but not a fire in surance policy on the house that has no cash value.

Volatility-linked securities are hedging instruments that are just an attachment to a real

asset class (Huebscher, 2009).

Investment risk is commonly measured by volatility. In the plainest sense or simplest words

volatility is the description of how returns have or might vary over a period of time.

As the study suggests there are others who might view volatility as an asset class worth

investing in. This gives rise to the foll owing questions: -

1. How is volatility an asset class?

2. How does is compare to other fairly new asset classes case in point Infrastructure ?

3. Does is fit the bill for asset class status against definitions of asset class ?

4. Of what value is volatility trade?

5. How does the trading in volatility affect underlying shares?

These questions have been refined through this literature review and a set of polished

questions are derived at the end of this review. These refined questions are set as the

research questions.

One cannot talk about volatility without first beginning with the explanation of Black -

Scholes model. Black-Scholes model is a model of price variation over time of financialinstruments such as stocks that can, among other things, be used to determine the price of

a European call option. The model assumes that the price of heavily traded assets follow

a geometric Brownian motion with constant drift and volatility. When applied to a

stock option, the model incorporates the constant price variation of the stock, the time

value of money, the option's strike price a nd the time to the option expiry. This model is

also known as the Black-Scholes-Merton model.

Trading in volatility comes with a warning, Volatility trading is high level of risk to yourcapital with the possibility of losing more than your initial investment. These products may

not be suitable for all investors, and are only intended for people over 18. Please ensure

that you are fully aware of the risks involved and, if necessary, seek independent financial

advice. (www.intertrader.com)


9/57

9 | P a g e

If it bears so much risk it begs to question its difference from gambling. Can one make

educated guesses and still come up with profits or at least not lose their capital?

Given the nature of the asset as the name suggests is volatile why and when one can safely

engage in volatility trading?

To better understand the question at hand the subsequent discussion on this review of

literature will be in a series of questions in three parts. This is due to the simple fact that the

researcher seeks s a comparison between two asset classes using the asset class definition

as a reference point. This is with a view to have a general perspective on volatility as an

asset class using comparison as a way of pinpointing similarities and differences against a

defined standard for asset class. Infrastructure as an asset class is used as a comparative

asset class this is due to the fact that both started at about the same time and both arespecialized assets which require professional tailoring and guidance in their utilization.

What is Volatility? Towards a definition:

There is a need to start this paper with an attempt to define what volatility actually is. It

refers to the spread of all outcomes that are likely to occur of an uncert ain variable.

Financial markets are typically concerned with the spread of asset returns.

FOW (2008) defines volatility as a measure the swiftness in the changes in price i.e.statistical volatility (SV) and the expectation on what the price ought to do i.e. Implied

Volatility (IV).

Ibid (2008) digs deeper and points to volatility being a reference to the amount of

uncertainty or risk in the size of the value of the security; the higher the volatility the

greater the potential of spreading the value of th e security over a large range of values

essentially meaning the value of a security can fluctuate dramatically over short periods

upwards or downwards. Whereas a lower volatility means that the value of a security

doesn t fluctuate dramatically but accommodates change in value slowly over an extended

period of time.


10/57

10 | P a g e

Volatility and risk are related but they are not one and the same thing. While risk is

associated with outcomes that are not desirable volatility is a measure that in strict sense

looks for outcomes that are desirable.

Volatility is much more than a mere measure of uncertainty levels in the market in recent

years it has become an important asset for investors looking to improve their portfolios

(Giese, 2010).

Schmanske (2009) Brings out comparisons of volatility to temperature time and speed and

determines volatility to be a description of the current state of risk. (Schmanske, 2009) He

goes further to liken volatility to an expirat ion date or interest rate or spot rate and

concludes volatility is but an element in the pricing model. He does not stop there but gives

a parallel against gold and its similarity to volatility where gold is a store of monetary value,it has no yield, and it generates no revenues and is termed as the anti -Currency . Volatility

against gold is the price at which value is held with different degree of risk threshold and

implied volatility can be said to be a store of risk value.

Volatility is of two types: -

y R ealized Volatility

y Implied Volatility

R ealized Volatility

This is also known as historical volatility and active (alpha) investment returns are based on

it (J. P. Morgan Securities Limited, 2008) . The Realized volatility (K,T) of an index, as

implied by the current price of a particular European-style option with strike K and

expiration T, is the volatility parameter that, when entered into the Black -Scholes formula,

equates the model value to the option price. (Derman, Kamal, Kani, McClure, Pirasteh, &

Zou, 1998)

Implied Volatility

The ambiguity over the value of future prices is what is termed as implied volatility. This is

the drive behind risk premium (J. P. Morgan Securities Limited, 2008) (the higher internal


11/57

11 | P a g e

rate of return (IRR) on risky assets that compensates risk-averse investors for this

uncertainty) (Panigirtzoglou & Loeys, 2004).

What this means is that the higher the risk premium the higher the risk and this essentially

shows up in prices from which the local volatility is derived. The Imp lied volatility (S,T) of

an index at some future market level S and time T is the future volatility the index must have

at that time and market level in order to make current options prices fair. Local volatilities

can be extracted from the set of all implied volatilities (K,T) at a given time, and locked in

by trading portfolios of currently available options. (Derman, Kamal, Kani, McClure,

Pirasteh, & Zou, 1998).

A Bit of History, towards showing progression

Volatility has its beginnings in the year 1986 with the advent of the Volatility Index (VIX).The figure below shows how volatile the VIX was when it started in 1986. In 1992 the

amount o of volatility started having a downward trajectory staying below 20 up until 1996.

In the beginning of 1997 volatility started having an upward trajectory up un til the year

2003 and the downwards between 2004 and 2006.


12/57

1 2 | P a g e

F

Fig 1 Source The encyclopaedia of Options Trading (2011)

From the year 2006 the market appreciated steadily up until the year 2008 when the market

sunk the worst it has ever been.

It is prudent to note that the 1987 market crash did not actually happen as VIX hadn t been

introduced and volatility trading had not yet started but the crash is as a result of reverse

engineering data that was available from the period and coming up with charts an d data

that show how badly the market slumped.

Post 2002 when the market started to head south those who invested in volatility managed

to have had a positive result as volatility provided a perfect hedge.


13/57

13 | P a g e

Fig 2 Source The encyclopaedia of Options Trading (2011)

What are the features of volatility? Towards a mental image

The basic features of volatility are: -

1. It does not produce direct returns in the form of interest or dividends (Giese, 2010).

2. Volatility tends towards medium levels in the long run and cannot grow to arbitrary

high or low levels;

3. Unlike equities volatility does volatility exhibit long term upward trajectory but it

typically shows short periods having high volatility which is ter med as volatility


14/57

14 | P a g e

jumps this is normally followed by a downward trajectory to level out at the medium

long term trajectory. This can be explained arithmetically to be the influence of the

heteroscedasticity element in the return on equity, that is to say e quity returns are

stochastic with the variance of the underlying probability distribution varying itself in

time (Giese, 2010).

4. There is an inverse relationship between volatility and equity markets this means

that when the m arket is rising volatility is falling and when market is falling volatility

tends to be on the rise. This is termed as negative correlation between volatility and

the equity market

5. Averagely the amount of implied volatility tends to be higher than that of realised

volatility. This is basically due to investors having to pay a risk premium to the

protection seller when buying protection in the form of options (Giese, 2010).

What is VIX? Towards an Understanding

The VIX is also known as the fear gauge by investors, it is an index that is calculated on a

real-time basis every day. It essentially is a measure of volatility and not price. It has its

beginnings in the year 1993 and was conceived with two main purposes: -

1. As a bench mark of market volatility in the short term with a view of providing a

comparison between past and present levels of VIX per minute from the beginning

of 1986. This helped give the market situation during the market crash of 1987.

2. It was created with an intention of creating a platform or an index upon which

contracts both futures and options could be written.

There is social benefit derived from the trading of which has been recognized with the

launch of VIX futures contracts in May 2004 and VIX option contracts in February 2006 by

the Chicago Board Options Exchange (CBOE) (Potter, 2008).

Essentially volatility means the random movement upwards or downwards of the market.Investors are continually trying to hedge and continua lly more investors are buying volatility

as a means of reducing their losses in the event of a drop in the stock market. This is likened

to the idea of purchasing fire insurance as a means of insuring value of a property against

the possibility of a fire. But when there is a fire in the neighbourhood of the said insured

property the likelihood of the insurer increasing coverage chargers is extremely high. This is


15/57

15 | P a g e

also true in the case of insuring a portfolio. Essentially the higher the demand by investors

the higher will be the cost of portfolio insurance (Huebscher, 2009).

Therefore VIX becomes a measure of portfolio insurance.

It might not be discernable from weekly figures but the highest level the VIX ever reached

was a 100 and this was in 1987 during the market crash. This is not discernable as the VIX

index was not in operation at the time and the figures for that period are as a result of

reverse engineering.

In 1989 there was a crash but the magnitude of this was not so much as that in 1987 and

was as a result of United Airlines Limited blunder in restructuring. This was followed by an

accelerated increase in 1990 due to the invasion of Kuwait by Iraq. There was another jump

in 1991 which corresponded with the United Nations Forces invading Iraq. There was a lull

until 1997 when there was another jump which was due to a stock market selloff. Then in

1998 due to general nervousness in the market there was another jump. In 2008 there was

another spike and the world is still struggling to get on its feet due to the magnitude of the

fall in the market. The market tends to even out after each jump but the 2008 jump has

taken almost 3 years and lots of Government interference to help restore and bail out

institutions. It will also be important to mention that the reason for the market crash of

2008 was mainly due to oversight within the banking industry they apparently got so muchwrong that to pinpoint particular reasons for the crash would basically be putting more than

half of our financial institutions on trial. The reasons for 1987 crash and those for the 2008

are not so different they are simply inability or incapacity or gen eral disregard for past

lessons (Potter, 2008).

VIX evolved further with the invention of Exchange Traded Notes (ETNs) which are based on

VIX. This opened the trade of volatility to retail investors (Stock, 2011).

y The VXX was created in 2009 and is tied to the first and second month contracts

(short-term VIX futures).

y The VXZ was created in 2009 and is tied to the fourth, fifth, sixth and seventh month

VIX futures contracts (Mid-term).


16/57


17/57

17 | P a g e

Options represent contingent payoffs with limited downside risk and unlimited upside

potential. A long option position can correctly be viewed as a form of insurance: an investor

pays an up-front option premium in exchange for a pote ntially large payment in the event

the underlying asset price falls (for puts) or rises (for calls) significantly. From this insurance

perspective, the implied volatility spread over realized volatility can be viewed as the fair

return premium option selle rs are paid for bearing the risk of underwriting the insurance

that an option represents. (Brandhorst, 2010)

Infrastructure as an asset class

For comparative purposes the author has chosen Infrastructure as a comparatively asset

class to volatility as it is also a fairly new concept in order to weigh the resultant against the

initial test question on the admissibility of volatility as an asset class category.

Investing in Infrastructure is born out of strained government bud gets leaving governments

seeking private funds and economic uncertainty that is leaving investors in a lurch looking

for more stable investment options. It originated from Australia in the 90s and has extended

to Europe and America (Evans, 2009).

In the OECD entry for infrastructure it defines it as: The system of public works in a

country, state or region, including roads, utility lines and public buildings.

In the investment context, it typically includes economic infrast ructure , in particular

Transport ( e.g. ports, airports, roads, bridges, tunnels, parking);

Utilities ( e.g. energy distribution networks, storage, power generation, water, sewage,

waste);

Communication ( e.g. transmission, cable networks, towers, satellites); and

Renewable energy; as well as social infrastructure such as

Schools and other education facilities;

Healthcare facilities, senior homes; and

Defence and judicial buildings, prisons, stadiums.


18/57


19/57

19 | P a g e

9. Insensitive to Changes in Technology Low risk of redundancy or technology

obsolescence decreases overall investment risk (The Pensions Institute, 2010).

What forms do investments in Infrastructure take?

Investments in infrastructure take three main forms: -

y Private equity-type investments , predominantly via unlisted funds (mainly closed-

end but also open-ended);

y Listed infrastructure funds (closed-end or open-ended); and

y Direct or co-investments in (unlisted) infrastructure companies

Infrastructure has several benefits: -

y Based on Porter s 5 forces model infrastructure as an asset class offers an attractive

risk adjusted return due to the many barriers to entry and its q uasi-monopolistic

characteristic. This essentially means that the performance of infrastructure assets is

not sensitive to cycles in economy unlike many other assets. There is increasing

demand for essential services; infrastructure businesses enjoy long -term protected

revenues and regulation which translates into low risk levels (The Pensions Institute,

2010).

y There is low correlation between infrastructure assets and traditional asset classes

(J. P. Morgan Securities Limited, 2008) . There are differing levels of correlation with

equities across the infrastructure spectrum, depending on what lies behind the

business. For example, some business drivers are more closely related to GDP

growth (such as ports), while others are more closely related to population growth

(like water utilities). (Weiner, 2008)

y Investments in infrastructure have high and predictable cash flows. This leads to

lower costs in terms of financing which leads to a situation where returns are

maximised (J. P. Morgan Securities Limited, 2008).y Investments in Infrastructure are subject to tight price-control regulation and which

are also operational in developed markets. For example, water companies in the UK

have cash flows that are often supported by agreed pricing mechanisms with

government or other authorising bodies that enable prices to increase in line with

inflation. (Ibid)


20/57

20 | P a g e

Infrastructure assets also face a number of risks albeit being a low risk asset class. This

include: -

y Regulatory risk due to the basic fact that infrastructure assets are regulated by

Governments and Governments keep changing or the policies thereof. Thus politics

becomes one of the risks to contend with in infrastructure assets especially in

developing markets

y construction risk occurs especially in investments into new projects which may have

delays therefore inflating the costs in the process increasing the volatility of returns

y Cost of borrowing may increase over time with it the ability to pay dividends and the

solvency of the company falls in doubt. This is basically due to the method of

financing of infrastructure assets due to the huge capital outlay.

Talking of risk without the concept of return is an incomplete assessment of the asset class

therefore return in this class of assets may be better explained by the practitioners. Since

many infrastructure funds are fairly new, they have relatively short track records. However,

internal rates of return (IRR) are on average between 10% -22%, Analysis of listed

infrastructure stocks over the last 10 years shows annualised returns of 9.84%, compared

with 7.95% for bonds and 0.42% for equities2. The annualised volatility on listed

infrastructure over the same period was 15.71%, compared with 6.14% for bonds and

16.75% for public equity. (J. P. Morgan Securities Limited, 2008)

What is an asset class? Towards a setting a benchmark

An asset class is a group of securities that exhibit similar characteristics, behave similarly in

the marketplace, and are subject to the same laws and regulations. The three main asset

classes are equities (stocks), fixed-income (bonds) and cash equivalents (money market

instruments) (JCB, 2011). JCB (2011) gives only three asset class categories while another

author gives four categories essentially adding a fourth asset to the mix namely Real estate

or tangible assets.

The basic utilisation of asset classes is in the process of allocating assets in a bid to control

risk and return in a particular portfolio. This is the decision as to how much of the sum total

is sunk into different Asset classes.


21/57

21 | P a g e

An alternative or complimentary definition of an asset class is in reference to characteristics

and deems assets with similar characteristics which include their risk and method of return.

Asset Classes can also be divided into different asset classes.

Traditionally an asset class is defined using its innate characteristics of the underlying assets

these characteristics should be identifiab le and have common economics, legal regulations,

have an identifiable correlation, comparable risk and return attribute, ability to be captured

by investible passive benchmarks. In traditional sense volatility is not an asset class but an

asset characteristic.

Apart from the traditional view there s a separatist view that takes a more pragmatic view in

its attempt to define what an asset class is. And it s from this perspective that volatility gets

its sting as an asset class as has a legal structure that is separate while managers treatvolatility as an asset class in its own right with its own market base, different skills

requirement to enable o e trade in volatility and it has drawn a distinction between itself

and already established asset classes

Asset classes and asset class categories are often mixed together. In other words, describing

large-cap stocks or short-term bonds asset classes is incorrect. These investment vehicles

are asset class categories, and are used for diversification purposes.

The basic features of an asset class: -

1. They typically appear in positive net supply that is to say there is an association

between future cash flows claims and assets generating this income in an economy

(Warren, 2010).

Inference from literature review (conclusion)

One author in his paper starts with the words mention the word volatility to an investor,

especially in these recently turbulent times, and what comes immediately to mind is risk,sudden change, erratic behaviour, loss and uncertainty; certainly not investable asset class

(Brandhorst, 2010), while another starts his paper by trying to define what an asset class is

and ends up with an asset class being defined as a set of assets that have som e fundamental

economic similarities to each other and that have characteristics that make them distinct

from other assets that are not part of that class (Greer, 1997), While put to another the


22/57

22 | P a g e

concept of volatility as an asset class is the latest result of the never -ending quest to create

products for consumption by the investor community. But while it may serve a useful

purpose as a measure of investor sentiment, it is only a true asset class for the marketing

purposes of Wa ll Street s financial engineers (Huebscher, 2009), Kuenzi et al (2006) in their

paper that relates to the idea of choosing a volatility model go ahead to term volatility as an

alternative beta which is a risk premium that is c aptured by hedge fund managers and

investment bank proprietary traders that of late is edging closer to the main stream and

therefore should be regarded as a veritable asset class (Kuenzi, 2006).

Various products deliver exposure to volatility as an investment in its own right, including

VIX futures, variance swaps and managed volatility funds (Warren, 2010).

The comparison is brought out very clearly by (Huebscher, 2009) between volatility,underlying assets and their relationship he brings it out thus the houses is an asset the fire

insurance policy on the house on the other hand is not an asset and does not add any

monetary value to the house, this simply put and relat ed to underlying assets and volatility

will be as follows, the underlying assets are what we interested in the volatility of such

assets has no real value to the investors interested in the underlying assets. Therefore

securities that are linked to volatility are used as hedging instruments that are just an

attachment to a real asset class. He concludes that if we do call volatility an asset class it will

be a bit of a stretch. If you are talking about purely speculative transactions ( I am long

volatility or I am short volatility ), it is really nothing more than legalized gambling. You

may as well be betting on sports events (Huebscher, 2009).

Exposure to volatility (or variance) will generate future payoffs with particular features

(Warren, 2010) they proceed to question the ability of an investor to benefit from the

exposure to volatility or variance added into their portfolio. (Inman and warren, 2010)

Continue to down play the classification of volatility as an asset class by terming it irrelevant

but they however state that when looking at the bottom line of what really is volatility they

would come down on the side of saying volatility exposure is NOT an asset class in the true

sense. Generally asset classes appear in positive net supply, i.e. they are associated with

claims over future cash flows generated by assets in the economy. In contrast, all volatility


23/57

23 | P a g e

exposure amounts to contracts between two investors that do not generate any net cas h

flow, i.e. a zero-sum game in which gains and losses offset.

Volatility products are akin to derivative contracts which exist in zero net supply. The term

volatility can represent various things, and is often used loosely. In investment markets,

volatility can be used in a general sense to refer to the variability of asset prices or returns.

While all assets implicitly bring exposure to volatility in a sense, the focus here is a range of

investment products whose payoffs are based around some measure of asset volatility.

There is an attempt to bring out a comparison between volatility as an asset class and

Infrastructure as an asset class using the definition and features of asset class as a basis

made the researcher come down on the side of volatility NOT being an asset class but this is

purely on the basis of material collected.


24/57

24 | P a g e

R esearch Methodology

Introduction

The range of approaches used in the collection of data in educational research is what is

referred to as methods and the main objective of methodology is to help in the

understanding of the processes of scientific research and not the products thereof (Cohen,

Manion, & Morrison, 2005) .

The chapter of research methodology will begin with a concise statement and will basically

be an overview of the methods and procedural aspects of the research. It will seek to how

the research was designed; present argument for chosen research strategy i.e. s tructured

interviews; a discussion on choices made in terms of different asset class chosen for

comparison and finally a summary of the whole chapter.

R esearch Problem and Questions

y When you talk of volatility as being at 100 what do we actually mean?

o When speaking of volatility at a certain level what does this mean?

o Does this have an effect on other factors that generally have a relationship

with volatility assets?

y Who decides and how as to what fits an asset class?

o Is there a body that regulates what fits into different asset categories?o What factors cannot be overlooked in decisions of asset class decisions?

y How does the trading in volatility affect underlying commodities?

o What we are essentially interested in is the basic commodities; in essence the

gold, platinum, oil etc that are the underlying commodities are what we are

interested in, therefore how does the trading in volatility affect this

commodities? Does it have any effect? If yes, is this effect positively

correlated or negatively correlated or is there any correlation at all?

o Research opines that volatility has a negative correlation to the market when

the market fall volatility increases how can this be captured into an inves tor s

portfolio?


25/57

25 | P a g e

y What really is volatility is it an Investable asset class or it remains an asset

characteristic?

o All assets have the element of volatility where there value rises and falls

therefore there is no question of volatility being an asset charac teristic butthis volatility is being traded as an asset class, does it fit the bill?

o As it does not bear all other characteristics that other asset classes have what

is it about volatility that endears investors to itself?

o Is it a marketing gimmick of financial firms as others notably (Brandhorst,

2010)have termed it to be no more than a gamble, does it pay off and how?

y What forms do assets under the volatility class take?

o Going long to hedge portfolio risk, most notably with respect to equities

o Going short to capture the volatility risk premium

o Trading Volatility.

y How does Volatility Compare with other new asset classes?

o Does volatility have any similarities with traditional asset classes?

o How does it compare to infrastructure as an asset class?

y In comparison with defined standards of an asset class does volatility fit the bill?

o How does it compare to what traditionally is the benchmark for asset class

status being bestowed on a class of assets?

Justification of paradigm and methodology

Garcia and Quek (1997) opine that the use of a specific technique in both the assumptions

of research and its theoretical framework is the main purpose of discussion with an aim of

qualifying their use.

A paradigm is defined by many an author as a wholesome approach at the core of research

methodology. While methodology is focussed on the approach we use to come to an

understanding paradigm is a reflection from the viewpoint of knowledge. In essence how we

arrive at the knowledge (Trochim, 1998).


26/57

26 | P a g e

The main objective was to ascertain the place for volatility trading as a whole that has been

offered by financial practitioners as an asset class in its own right. It was important to look

at it from the perspective of the practitioners actively trading volatility as an asset class,

those that do not agree with the analogy of asset class status to volatility and ultimately the

consumer (identifying consumers for this products is an uphill task thus data from

Government financial policy utilised).

In this study it is the history, characteristics, approaches and behaviour of volatility against

those definitions, characteristics and behaviours that are generally accepted as standard for

assets to fit the bill as an asset class. This is further evaluated against another failure new

entrant into the asset class category the infrastructure class of assets to deduce the

similarities in the two groups of assets against those of standard asset class.

This section is essentially an outline of the way in which data was collected and analysed inline with the selected research approach. The line of thought and knowledge base and how

it was acquired is explained. A description of interviews structure and how they were

conducted is also provided.

R esearch Design

The main objective of research design is to bridge the questions to the data. It is the thread

that shows how the data connects to the research questions. It needs to show how data fits

with the research questions and what methods are employed in answering these researchquestions. Punch (2000) opines that research design is the foundation for empirical research

including strategy, sample, ways and methods employed in the collection and analysis of

empirical data.

Research design will only dwell in strategies employed and the general research sample.

Methodologies are varied and their use is the evaluation of data from a multitude of

empirical judgements. Different methodologies have different strengths and weaknesses

and many researchers have come down on the side of employing not a single methodology

but a multitude of methodologies with a view of triangulating results. This enhances the

quality and reliability of the findings.


27/57

27 | P a g e

R esearch strategies

Figure 2.1below gives a description of the generic research process onion . This research

process renders support to a researcher to represent the issues involved in the selection of

methods in the collection of data. (Saunders, Lewis, & Thornhill, 2006).

The research process in the form of an onion represents the following aspects of a research:

y Philosophy of the research;

y Approach employed in research;

y The strategy or methodology employed in research;

y Time aspects in relation to research; and

y Methods employed in the collection of d ata.

Fig 2.1 The Research Onion source: Mark Saunders, Phillip Lewis, Adrian Thornhill; 2006.


28/57

28 | P a g e

There are two main methods in the conducting of empirical research: Qualitative and

quantitative. These methods both have their shortcomings and highlights. Qualitative

research enables a researcher to make an exhaustive study into the area of research and its

approach does not limit the researcher in terms of depth, reach and structure of qualitative

research. It produces a large amount of detailed information on small populations and

scenarios/cases. On the other hand quantitative methods need structures, specialised tools,

in order to limit responses to suit a given framework; it has the ability to measure the

responses of a lot of people using few questions therefore becoming a useful tool for

comparison and statistical analysis.

Qualitative methods increase understanding research due to its limiting factor (Pat ton,

1990). This brings us back to the triangulation where the use of both qualitative and

quantitative methods in a bid to reduce both their weaknesses while enhancing theirstrengths.

In this study only two methods were utilised mainly due the researcher s oversight in

selection of research topic under the belief that qualitative methods (literature Review)

alone were sufficient but along the line the need for quantitative research could not be

wished away therefore interviews were carried out.

This was dictated by the research questions and the explanation for this selection is given

below.

Literature R eview

Most all the research questions were descriptive in nature therefore the need for a

descriptive study. Where, descriptive study is the sum total of collecting, organising,

summarising information on the subject of study. The main concern of a descriptive study is

to make complex things simpler to understand. Literature review on all aspec ts of volatility

trading, asset class, infrastructure as an asset class helped in the analysis of the asset class

tag bestowed on volatility assets.

Interviews

A small number of interviews were carried out with personalities in the financial world who

have a say on their company policies and general direction. Selection of people to be

interviewed was done using LinkedIn as website that is used for connecting professionals

from different parts of the world where people post their curriculum vitae s and from this a


29/57


30/57

30 | P a g e

y Observation

y Self-reporting

y Archival/documentary sources

y Physical sources

The research undertaken employed the self reporting method. This method is characterised

by face to face interviews. The data collected using this method is raw and of high quality.

The interviewees were briefed on the topic of study, technical and legal issues and ethical

issues among a host of other issues arising from the research. This method however proved

difficult due to the difficulty involved in the process of arranging for interviews given the

busy schedule of the interviewees. This is also the r eason why other forms of interviews

such as focus groups were untenable as methods of collecting data.

Miles and Huberman (1994, Pg 27) believe that in qualitative research the researchers are

usually restricted to a small population of people within the ir primary area of interest.

Merriam (1988, pg 48) describes the purposeful method of sampling that has been

employed in this study as a method that seeks understanding, discovery, insight into an area

of research which brings about the need to select.

Interviewees were selected with specific criteria, this criteria needed to be satisfied for theselection to bear any real meaning. This selection needed to be based on individuals with

capacity to choose or make investment decisions for their organisations . In simpler words

individuals with working knowledge on subject matter (Folch -Lyon & Trost, 1991 pg 444; as

cited by Bothma, 1997 pg 35).

The researcher initially targeted a total of five interviews but due to time constraint and

difficulty in obtaining and arranging for the interviews an end date was chosen after which

the number of interviews available up to point were taken and the rest rejected in order toallow and facilitate analysis. And at the end of the chosen end date only three interviews

had been scheduled and after being conducted the researcher deemed them to be

satisfactory and information received was repetitive in nature.


31/57

31 | P a g e

The interviewees were selected by use of browsing through publicly available curriculum

vitas through the website LinkedIn; this was followed by an assessment of individual

suitability to the study based on present position or past experience. Some control

questions were formulated. These questions included: -

y What does the researcher want to know?

y What knowledge is the most critical?

y The most suitable source of this information?

y Purpose for the required information and the end users?

y What methods will be employed in contacting the prospective interviewees?

Finally the research involved three senior individuals in the field of volatility trading

essentially having published a few papers on the subject. There was need to find andinterview very senior policy makers in their respective institution. Given that the subject

matter was specialised in terms of its use the policy makers were a perfect fit in terms of

acquiring relevant information that was not riddled with hearsay.

Interviews were conducted in the interviewees place of work this enabled the ability to use

observation a mode of research. Although three int erviews were conducted ten requests

were sent out to request for interviews, three were positive and interviews were carried

out, a further two were rejections and the rest were no shows.

Instrumentation

Mouton (2001, pg 103 -104) gives a guide which is based on the use already established

research goals and objectives in the formulation of interviews.

The use of critical open-ended questions was employed. These questions were identified

from the research questions, phrased appropriately from the very gene ral to the very

specific questions in what is normally known as the funnel process. This can also be termed

as going from the questions with the greatest importance to those with least importance;

this is also done with a view of using time to get answers to the most important question in

case time runs out. The questions for the interview were arranged in the following order: -

y Question aimed at getting the discussion started;

y Question aimed at formally introducing self and subject matter ;


32/57

3 2 | P a g e

y Question aimed at creating a bridge between the different areas of interview;

y Questions pertinent to the subject of study ; and

y Questions aimed at obtaining final summarisations.

The questions utilised in the research were formulated and polished prior to the int erviewand due to the fact that the researcher hoped to utilise the semi -structured form of

interviewing lots of room was left in the hope that the interviewees will have some wiggle

room in terms of the flow and direction of discussion. This method prove d to be very handy

and effective as it elicited personal views from interviewees which outweighed questions

that had been prepared.

Questions employed in the interview process were obtained from the literature review

section of this research and fine tuned to suit a face to face interview. There is aconsiderable amount of grey areas that arises from the literature review and some of these

areas were fine tuned by using the interview process to throw a little bit more light on

them. There is a considerable amount of information relating to the status of volatility and

especially its classification as an asset class. This conflicting information on volatility asset

status formed the basis for questions employed in the face to face interviews.

The questions were limited to just a handful and open ended in their nature. This was done

with a view of eliciting the views, opinions, insights and reactions from the interviewees(Creswell, 2003, pg188).

The major outcome that the researcher hoped to achieve from t he face to face interviews

was the general industry sentiments on the issue, the general industry practice on the

classification of financial products, the individual concerns, general feedback and any other

underlying factors that the researcher might hav e overlooked otherwise.

Questions were mixed up with the view of satisfying choice of interviewee in relation to

knowledge on the research subject. These questions were personal in nature in line with

interviewees past, experience, present roles, personal achievements and general

contribution to the study of volatility trading.

These questions were followed by questions relating directly with interviewees personal

perception on the subject of study and whatever input in terms of researcher s choice of


33/57

33 | P a g e

topic in relation to the field in general. This is followed by specific open ended research

questions.

Interview No. And Date 1 29 th March 2011 2 30 th March

2011

3 5 th April 2011

Time and Place of

Interview

London 2 p.m. London 3 p.m. R eading 11 a.m.

Job Title Team leader

Securities

Vice President Head Of

Department

Length of Interview 45 Minutes 1 20 minutes 95 minutes

Voice Recorder Use Allowed Allowed Allowed

Other Negative Factors Nil Nil Nil

Table 1 Author

Qualitative data has a lot of characterisation in the form of verbal information (Merriam

1988, pg67) and (Miles & Huberman 1994 pg9).

In this study the main method of data collection that was the interview method. This

interview method was coupled with voice recordings from the conducted interviews. The

interviews were later transcribed and a verbatim form of these interviews was to be

employed for the purpose of analysis. There was also a bit of observation given that all the

interviews were conducted in the interviewees places of work. The re is need to transfer

collected data into a more readable format (Maykut and Morehouse 1994 pg127) this is

done with a view of making sense out of collected information in a quick and timely manner.

This is also done against the background of the information gathered from the use of

available literature in the preceding chapter the literature review.

Analysis of Data

Data analysis is the sum total of selecting, polishing, sorting, focusing, discarding and

organisation with a view of getting a better understanding of information collected,

combining this information in a manner that makes the most perfect sense and drawing

conclusions from the information collected (Merriam, 1988 pg127; Miles & Huberman, 1994


34/57

34 | P a g e

pg10). This allows the researcher to harmonize collected information and while enjoying the

benefits of drawing conclusions based on data collected and analysed.

Interviews have the ability of generating primary information, expressions, views, opinions

and insights from the interviewees . The interviewees gave the best view of the financial

market looks like in terms of volatility assets and their combination into an asset class.

The information underwent a further three stages that are defined by Miles & Hube rman

(1994) as: -

1. Data Reduction: data was reduced from any format that it was in and any concepts

therein were explained and these were followed by a summarisation of the data and

the assignment of categories.

2. Data Display: this reduced data was then displayed in the most suitable format in its

different categories or against each other in favour of suitability.

3. Conclusions: this was followed by the drawing of conclusions and the verification of

the data collected. The data that is now in a format that th e researcher deems to be

the best in view of the research is then discussed to the fullest.

Validity and R eliability

The importance of maintain a scientific ethos and spirit is crucial in all forms of research

(Merriam 1988 pg163-165). This is done with a view of producing relevant, up to date and

valid information that is reliable and ethical in its nature.

Internal and External Validity

There are control questions that are employed with a view of ascertaining the extent of

validity of information gathered and produced by a research. These questions are: -

y What is the correlation between what the researcher is collecting and what he is

reporting? Do these two meet at a point of agreement or disagreement? The

researcher is meant to produce the world he is s tudying in a manner that portrays

the reality agreeable to the people in that world.

y What other sources of information gathering are being employed and how this two

tally do. This is with the aim of triangulating.


35/57


36/57

36 | P a g e

Studies on Volatility especially aiming at

establishing asset class status.

Research that doesn t have information

regarding volatility asset class status.

Studies carried out from 2008 to date Studies before 2008

Published Government or Organisation

research reports

Studies which duplicated results of the same

study.

Search terms

Volatility VIX

Asset Class United Kingdom

Volatility as an asset class AND Economy

Trading volatility Existing methods

Volatility trading statistics Equities

Infrastructure as an asset

class

Derivatives

Infrastructure trading Volatility trading

The search process was adopted for transparency and less bias. Databases were employed

in an attempt of narrowing the search and final selection of articles.

The database search was conducted through the UWIC portal using my password provided

by the university. First with EBSCO the term volatility as an asset class was entered in the

search box and a thesaurus mapping of the key words was done with the view of gaugingthe scope and this was followed by the selection of appropriate terms and started the

search. This search was limited to articles with full text. I also employed the use of Boolean

operators in combination with my initial search which altered the search results albeit

marginally. The search was further limited with only papers in English and published

between 2008 and 1011. The search results were analysed using the criteria set for inclusion


37/57

37 | P a g e

and exclusion. The justification for using EBSCO is that it is a comprehensive database of

journals in English language to their hundreds of thousands and it also host business

premier which hosts journals in the business field.

The database search was repeated in JSTOR which holds journals from 1665 to present and

is basically there for research students.

BOOKS

Reference books, electronic books were used to find the background information and

develop a lot of key words used to search for the abstracts and indexes. Dictionaries,

thesaurus and encyclopaedias were used (Ttart , 2001)

y Volatility Trading Euan Sinclair, 2008

y The volatility course, George Fontanills, Tom Gentile 2003

y The Volatility Edge in Options Trading: New Technical Strategies, Jeff Augen, 2008

Citations

These were identified electronic databases and are reliable if well searched (Burns and

Groves, 2005) eight of the studies were identified through citations.

Hand Searching

This helps identify the literature available in hard copies. A Search of the contents page of

relevant journals was conducted in order to identify other relevant articles. This approach is

very time consuming although five articles were obtained using this method which were

relevant to the study.


38/57

38 | P a g e

F indings, Analysis and Discussion

The most important factor affecting the classification of Volatility assets into an assets class

is the ease with which they can be capped together with any other assets with similar

characteristics. This is also reflected in the classification of Infrastructure assets into a class

of their own mainly due to the fact that there are no compatible assets.

The literature review starts with the work of (Huebscher, 2009) , who is of the view that

volatility assets do not fit the bill to be traded as an asset class but rather they should have

the same relationship that exists between a house and the fire insurance taken on the

house.

This view would be acceptable but according to R2 in t he interviews carried out there is no

problem with the refuting, the problem is with the provision of an alternative asset class tofit assets that have no similarities with any other t raditional assets, this view is also reflected

in the literature review by a host of other authors on the subject from Derman, Wiener to

the trading institutions who s literature tends to agree with the majority view on the

subject.

The literature review tried to draw a path in the genesis and growth of volatility trading and

its subsequent clasping into an asset class, this approach is backed up by the procedures

drawn out in the methodology section of this paper, which is followed by a preview into theworld of finance by a sneak peek into the opinions of three members of th is fraternity with

their somewhat different opinions.

Infrastructure is brought in to show an alternate asset without similarities with traditional

assets and fairly new. This comparison brings out the most important aspect in this study

which is consistency.

It is the belief of the researcher that in the endeavour to come up with new assets financial

players are tempted to come up with different products continually which results in a huge

array of products which are then grouped into different classes. A lthough this happens fast

there is a consistency with which classification has been acquired over time.

The conceptual framework of this study is based and focuses entirely on volatility assets and

their classification in conjunction with investments in in frastructure assets and its


39/57

39 | P a g e

classification as a class. All this was compounded under the banner of what an asset class

entails.

Based on information gathered in the literature review and responses from interviewees,

there will be a brief discussion on fin dings based on this two segments. This chapter is based

entirely on the answers to the research questions and seeks to make conclusions and

recommendations with future research being the sole purpose; this also includes

implications for alternative scenarios. The significance of this study to the financial sector is

also discussed.

This chapter will look at the findings analyse and discuss these findings as one. It is then

divided into sub-sections based on categories that are pre -determined for the purpos es of

analysis.

The interviews have been analysed as a whole but for the purposes of presentation of the

aforementioned analysis only certain excerpts have been included in this analysis. The

excerpts were chosen on the basis of their representation of en tire concept being discussed

and their ability to capture a clear picture of the research questions .

Main Study

Various analytical procedures were employed with the view of addressing the research

objectives set out in the methodology chapter in the form of research questions that the

study needed to address and answer adequately. Some of the procedures employed to this

end included but not limited t o: reliability, validity, performance etc.

Interpretation of the proposed framework

The researcher took the approach of coming from the known to the unknown by starting

from the historical perspective throwing more light along the way on factors the resea rcher

deemed to be pivotal in the fruition of the study.

This included facts in the form of risk levels and how they are measured and how the VIX

index works and against what backdrop is the volatility trade today built upon.


40/57

40 | P a g e

The existing scenario where volatility assets are continually being traded as a class of their

own albeit with some opposition seems to have a clear advantage over the alternative

scenario of banding them together with existing asset classes.

The present scenario gives the opportunity of creating portfolios that are adequately

hedged against market uncertainties all the while retaining the volatility characteristics and

the risk associated with it. The different products within this class of assets and how to

diversify to achieve a hedge that will shelter investment during down turn while retaining

the ability to earn during market growth.

Quotes that were felt to be outside the questions of discussion were not included (Banister,

1994)

When referring to di fferent individuals who were interviewed abbreviations will be

employed with the first interviewee being referred to as Respondent 1 or R1, and so on.

In order to give a clear representation of information obtained it is prudent to start with a

description of the interviewees this will enable the reader have a clearer image and provide

a context for analysis done thereafter.

The Interviewees

Interviewee one (R1) is a professor in finance and specifically in volatility modelling, studiedin the UK, America and Brussels, taught in a number of universities both in the UK, France

and USA. She has written a number of papers on volatility and correlations. At the time of

the interview she was about to move to Italy to take up a position and one of the leading

Financial institutions in Italy as a head of the finance department. During the interview the

interviewee was pleasant, receptive to questions and answered in great detail. She s been in

the financial industry for the last decade. Due to ethical consideration s her personal details

have been left out as per request from interviewee not to be identified.

Interviewee two (R2) works with one of the world s leading financial institutions and is in

charge of a transversal team that is entrusted with the validation of methodologies that

seek adjustment in the area of risk in the Risk Capital Markets. He has a wealth of

experience in the UK financial market with over two decades experience under his belt and

has risen through the ranks from a floor trader to head of o ne of the most important if not


41/57

41 | P a g e

the most important department within the organisation. He has direct access to the board

members. The interview was set against the background of a bad day with the organisations

daily profit and loss account showing an over a million pound loss and the frantic decision

making process to salvage as much as was possible. The interviewee was very friendly a

gentleman at best with an articulate short answer approach to questioning and the initially

planned semi-structured interview model could not suffice and a more structured approach

was undertaken. Due to sensitive nature of information and interviewee position a request

to put a seal on organisation and individual was requested.

Interviewee (R3) is the vice president of one o f the leading investment bank in the world

today; the interviewee was sharply dressed and had a sharp mind to go with it. As I asked to

meet him I could see the disbelief around me I could not understand it until much later

when I was informed by an administrator that even for employees to secure a meeting it

takes months on end. He was very friendly, maintained constant eye contact, quoted

repeatedly from history and we shared a belief on the man that was Abraham Lincoln

(Bigger than life). His area of exp ertise is commodity trading and has been instrumental in

negotiating a number of infrastructure projects as the Bank holds this kind of products in a

bid to diversify. His candid answers and ethical restriction on the interviewer are the reason

for the blanket cover on identity of this interviewee and his place of employment.

All the interviewees were professionals at the peak of their careers with working knowledge

of the financial markets and in particular assets and their classes. Two of the interviewee s

R1 and R3 were very open to the idea of semi-structured form of interviewing while R2 the

structured form had to be employed although in general the same questions were put

forward to all the three intervi ewees. Due to the sensitivity the information sought it there

was need to hold back on identities of the respondents

Data Analysis from Interviews

Volatility trading perceptions and Aetiology

When asked about their general understanding on volatility trading R 1 was more detailed

compared to R 2 and R 3 .


42/57

4 2 | P a g e

R1: Trading volatility is essentially trading on the underlying risk that all financial

products bear. This risk is quantified and traded as a hedging tool in the event of a

fall in the market. This is because volatility is negatively correlated with the s tock

market.

R2: Volatility trading is very vital in the financial markets of today given that it is the

perfect hedge against stock market fallings as they are negatively correlated.

R3: when talking about volatility trading at the back of your mind the constant factor

that continually plays is risk. It s traded as a product on its own which is acceptable

but not necessarily right. It plays an important revenue accumulation aspect with

billions invested in this market today with its only pull being its n egative correlation

to the stock market. Volatility is traded by making a combination of its static positionin the price of the options with the dynamic price of the underlying options.

Respondent one (R1) is the only one to delve into a bit of history o f volatility trading

R1: volatility trading has its roots in the beginning of the 1990 s although it s evolved

over time and the numbers of products have multiplied. When the Black Scholes

model was introduced it quantified the risk factor and rendered it possible to trade

as it could be quantified. This brought about the options market which evolved to be

traded over the counter (OTC) and volatility being traded on its own by applying the

model to different markets around the globe.

Volatility trading acco rding to the respondents answers although based on the different

aspects of the study is consistent with the literature on the subject.

This was followed by seeking a bold statement on the interviewees definition of volatility

R1: volatility is the dispersion of given securities or market indices measured statistically.

It is measured using two main ways the first one is done by utilizing the standard

deviation and the other is by using variance to measure returns from the same

security or market index.

R2: volatility is the variable in formulas derived with the aim of calculating the price of

an option showing the fluctuation of the option between now and its expiry. This


43/57

43 | P a g e

calculation of volatility affects or determines the value of the coefficient to be

employed.

R3: when I think of volatility I think of human movement, if I draw an analogy from your

day today before you got here and the pattern created. It can never reoccur it s the

same with volatility it s essentially that unknown that we seek to make a whole or

the connection between the underlying assets and their final prices on expiry.

Respondent three (R3) went into an analogy of events that are deemed to be the influence

of volatility or to be volatility itself starting fr om the market crash of 2008.

R3: If I may; I will take you back to the market crash in 2008 and the events prior to and

after. The market was at its peak at this point just before the crash, driven by the

bullish investment into the subprime mortgage marke t in the U.S. essentially banks

were lending to people who could not afford to pay and those who were trading

were privy to this information. When the stock market was falling, the volatility

assets were rising and they peaked at about 100. This was the highest point ever

against today s average of about 50. This continued shifting is the market from 100

to 50 at 60 tomorrow is what volatility is.

This line of answers was in line with literature. FOW (2008) defines volatility as a measure

the swiftness in the changes in price i.e. statistical volatility (SV) and the expectation on

what the price ought to do i.e. Implied Volatility (IV); volatility is a reference to the amount

of uncertainty or risk in the size of the value of the security; the higher the vol atility the

greater the potential of spreading the value of the security over a large range of values

essentially meaning the value of a security can fluctuate dramatically over short periods

upwards or downwards. Whereas a lower volatility means that the value of a security

doesn t fluctuate dramatically but accommodates change in value slowly over an extended

period of time.

Asset class status and Volatility

R1: generally an asset class is a group of assets that bear the same properties in terms of

movement and behavior; it is wise to note that volatility is a characteristic that is

borne by all assets including the risk-free assets such as Government bonds because


44/57

44 | P a g e

even those in extreme circumstances become depleted in their value. Volatility

classification as an asset class is basically as a marketing tool by finance players. This

is due to the fact the simple fact that volatility in its strictest sense is a chara cteristic

and trading it as it were means trading on a non -existing platform of existing

products.

R2: Volatility classification into an asset class may be the brightest financial idea of the

last decade. It opens up the arena of hedging with a tool that is sure to behave

contrary to the stock market giving rise to an alternative product and since even in

times of stock market gains the ability of volatility products to create value is a tool

like none other.

R3: When the need arose to find a replacement p roduct for the traditional asset classesthere was none that could stand the test of correlation with the stock market. With

the discovery of volatility it would be insane not to trade it as an entity on its own;

because where else will it fit; yes, it s i n every financial product as a characteristic

but this products are already being traded in their own right. Volatility is a product of

necessity.

R1 was completely against the concept of volatility as an asset class and termed it as a

practitioners gimmick; R2 and R3 agreed that volatility is an asset class on its own butconceded that when pushed to a corner it really doesn t fit the bill but still wise to trade it as

such.

Asset class status and Infrastructure

R1: Infrastructure as an asset class is a fairly new concept born in the 90s, with its roots

in Australia. The need for infrastructure assets arises as a need by Government to

source for funds to improve its infrastructure. It has essentially caught on in the

western world due to stability of their currency and politics. R1 was of the opinion of

viewing infrastructure in the same class as bonds (specifically Government Bonds) as

they both have the same characteristics; with the main one being they are both

backed by Government. The assumption made that this kind of assets has a lower


45/57

45 | P a g e

risk compared to traditional assets is not entirely true as their calculation does not

include factors that are really inherent in this kind of assets.

Generally investment in infrastructure assets is considered to be of low risk but

infrastructure investments are riddled by different types of risk due to their nature: -

1. Political/regulatory risk: - Arising due to regulation by Government this may occur

due to a change in regime or policy due to the fluidity of politics . This is particularly

rife in emerging economies.

2. Operational/construction risk: - this affects projects that involve a huge outlay in

terms of time required in order to turn around especially Greenfield projects.

3. Refinancing risk: - this mainly reflects the raising costs of servicing debt against the

backdrop of increased costs of borrowing.

R2: R2 started by stating that he had personally not traded in infrastructure as his

organization is more into traditional securities. However he thought it was an

amazing financial product as it came with factors that other assets do not enjoy like

Government backing and long life.

R3: R3 drew from personal dealings in the infrastructure class. He opined that the reason

it s in a class of its own is because it fits no other assets characteristic. A deal in one

of the South American countries in this regard has paid back into the portfolio

consistently irrespective of the goings on in the country. The need for infrastructure

cannot be relegated to an inferior position owing to the fact that without

infrastructure businesses suffer and in the end it s the government that has to take

the slack. The need for infrastructure and the scarcity of finances is main pull into

this area of investing plus the returns are steady and over a long time as assets in

this class have a life of not less than 25 years. Governments are learni ng to love this

kind of fund because once the infrastructure is in place it pays for itself while servingthe purpose it was intended for.

Discussion on Interviewers choice of comparison between Volatility a nd Infrastructure

asset classes


46/57

46 | P a g e

All the respondents agreed that the interviewer had chosen asset classes that had no basis

comparison and the only thing they had in common is that they started at about the same

time. But when requested to come up with an alternative they came up with none citing

the nature and uniqueness of these two asset classes. R3 came down on the side of a

comparison between volatility and volatility within a class of assets not th e class itself but

to carry that out is probably impossible.

Investment companies and volatility assets

R1: Investment companies are finding a volatility asset to be the perfect hedge against

market downturn this is especially prevalent in hedge funds. Investing in volatility

has been termed by some as financial gambling and the truth is some have lost

millions while others have made billions in this trade. It is traded on the notion of not putting all your eggs in one basket.

R2: Volatility has become such an integral part in portfolio creation that we (those in the

financial Industry) now wonder how it worked before. Volatility creates a perfect

ring around a portfolio and the capacity to make money out of volatility when

markets are falling or rising is an integral stone in understanding the pull volatility

assets have on the finance practitioner.

R3: There is continued need to create wealth. This need is coupled with maximizing what

we already have. Volatility has the capacity to fit different roles as signed to it in

times of austerity and more so in times of depression. It also has the capacity to be

understood against stock market movements an ever rising volatility index means

there s trouble coming up ahead.

The decision on asset class status

R1: The financial practitioners continually use these terms whenever they come up withsomething they deem to be new and they are trading it as such. There is no

particular body tasked with the task of classifying assets and is therefore basically

left to the practitioners. It normally starts with a single financial institution

bestowing the asset class status and other companies t rading the same in a similar

manner tend to follow suit. There is no arbiter on what should be an asset class or


47/57

47 | P a g e

not it is left to the jury of the investing public who has no financial background to

decide whether the practitioners classifications are right or wrong.

R2: Classifying assets into classes is the simplest of tasks much like deciding which

students go to which class. In the case of students the classification is made on the

basis of age. But it is still possible for a youngster to be in an advanced class for

his/her age depending on their intelligence quotient. This is the same with assets

classification those with basic innate characteristics are placed in different classes

and those that do not fit any classes are classified into classes of their own. This is

with the view of getting the maximum value out of these different assets.

R3: R3 starts by stating that he was part of the team that started the tag of

infrastructure asset class classification. They are like no other assets and thereforecannot be classified with any other assets. Just because it s an animal doesn t mean

it belongs in the wild; it could be domesticated; and just because it s in the wild

doesn t mean its wild. The scenario of classification into classes is not for the

practitioners benefit but rather the investor. The practitioner already has a working

knowledge of how the different assets behave; they ha ve different methods of their

combination. Therefore it s for the investors benefit that the tags are put in a bid to

make it easier to see how best to go about investing.

Volatility measure and its meaning

R3: When volatility is stated to be at a certain level it simply means that that the

standard deviation on the graph plotted risk against return with standard deviation

being the measure of volatility. This simply means that the higher the number the

greater the risk being undertaken and it should follo w that the greater the reward.

The subprime mortgage market was an example of a high risk investment which if it

paid off would have meant an extremely lucrative return for the investor and when itfailed the results were disastrous. When Abraham Lincoln d ecided to go to war to

keep the USA at one it was a huge risk and at his death the magnitude of the

situation played itself out with the triumph of democracy. The same is true to values

of volatility the greater the risk the greater the expected return.


48/57

48 | P a g e

R1 and R2 did not answer this question and R3 drew analogies from history on the effect of

risk and its return.

Volatility effect on underlying assets

R1: What we are essentially interested in is the underlying assets and if volatility had an

adverse effect on the underlying assets then belief is it would cease to be traded.

This means that it is the gold, the copper, the actual stocks that investors are

interested in and if volatility is messing this up then there would be uproar from the

traders and consumers of these assets. It therefore brings us to the conclusion that

volatility trading has no effect at all on underlying assets and even if there is any

effect, it is negligible.

R3: To the contrary underlying assets have an effect on volatility. It cannot work the

other way round. The movement of the market triggers movement in the volatility

assets.

Conclusion and R ecommendation

The trading of volatility as an asset class and most of the literature in the subject are

tailored to the needs of the practi tioner and the practitioner s point of view. Most literature

on the subject is from the point of view of the broker or the dealer s perspective rather than

that of the user who in this class includes pension funds, Governments, insurance

companies, individual investors etc. Therefore this dissertation sought to look at this issue

from the users perspective and not the manufacturers . This is despite the fact that it isfrom the angle of the manufacturer that a more comprehensive understanding is possible.

In volatility trading there are always two prices for each and every instrument unless it is

stated otherwise this is due to the simple fact that in economic theory there are always two

prices. One price is the price that a dealer is willing to buy a prod uct and the other is the


49/57

49 | P a g e

price the dealer is willing to sell the same product. It s the same principle applied by a

vehicle dealer. A vehicle d

Documents

Provisional Title