the art of hedging - cboe · the art of hedging 2015 cboe risk management conference arieaboulafia...

The Art of Hedging2015 CBOE Risk Management Conference

Arie Aboulafia

Senior Portfolio Manager

Capstone Investment Advisors

+1 212 943-0257

Please note, the following slides were part of a 30 page joint presentation. The two presenters were:

1) Arie Aboulafia, Senior Portfolio Manager, Capstone Investment2) Boris Lerner, Head of US Quantitative and Derivatives Strategy, Morgan Stanley

CBOE cannot post or distribute Boris’s slides.

Practitioner Approach

CONFIDENTIAL AND PROPRIETARY

IMPACT OF FLOWS

Source: CapstoneFor illustrative purposes only

Historical Skew as a Measure of Tail Risk

(25 delta put – 25 delta call)

-2.00

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

10-A

ug-10

26-Feb-11

14-Sep-11

1-Apr-1

2

18-O

ct-1

2

6-M

ay-13

22-N

ov-13

10-Jun-14

27-D

ec-14

15-Jul-1

5

SX5E : 12M : -25

SPX : 12M : -25

NKY : 12M : -25

Derivatives products are used to achieve many different objectives, including overwrite, overlay, beta

replacement, and alpha

• Flows drive the cost of option based derivatives products, which mean revert over time. Occasionally,

these flows will generate discrepancies in the implied volatility creating opportunities volatility traders.

• A recent example is the issuance of structure products in Asia, which has resulted in selling pressure on

low strike put options on EURO STOXX50 and Nikkei.

4


VOLATILITY ARBITRAGE TECHNIQUE APPLIED TO PORTFOLIO PROTECTION


700

800

900

1000

1100

1200

1300

1400

1500

1600

92

93

94

95

96

97

98

99

100

101

1-N

ov-98

1-M

ar-9

9

29-Jun-99

27-O

ct-9

9

24-Feb-00

23-Jun-00

21-O

ct-0

0

18-Feb-01

18-Jun-01

16-O

ct-0

1

13-Feb-02

13-Jun-02

11-O

ct-0

2

8-Feb-03

8-Jun-03

6-O

ct-0

3

3-Feb-04

2-Jun-04

30-Sep-04

28-Jan-05

28-M

ay-05

25-Sep-05

23-Jan-06

23-M

ay-06

20-Sep-06

18-Jan-07

S&P 5

00 Index

NAV

March 2000

- S&P 500 up 9.67%

- S&P 500 Variance portfolio up

1.2%

Portfolio 2: Long S&P

Variance swap (1% of Nav

is invested every year)

Portfolio 1: Long SPX 6 Month

90% put (1% of Nav is

invested every year)

S&P 500 Index

Performance comparison between long variance swap portfolio and long put option portfolio

• Equity return distribution is skewed to the upside, median returns are approximately 10% historically

• Volatility trading can be used to capture outsized moves regardless of direction

5


RELATIVE VALUE TOOLS HELP DRIVE ALLOCATION


The spread between

Euro Stoxx 50 index and

DAX index protection

(-10 delta , 6M)

increased by 150% from

11/24/2009 to 9/29/2010,

creating an opportunity

to source cheaper

convexity out of Euro

Stoxx 50 into the DAX

index.

Normalized Implied Volatility Surface by Delta and Rolling Maturity

Euro Stoxx 50 index DAX indexImplied Volatilty Spread (Euro Stoxx 50 – DAX)

Spot: 2,753 Spot: 6,247

Maturity Maturity Maturity

9/29/2010

Delta

1M 3M 6M 12M

Delta

1M 3M 6M 12M

Delta

1M 3M 6M 12M

-5 31.6 36.7 40.4 40.8 -5 25.7 31.4 34.8 37.1 -5 5.9 5.3 5.6 3.6

-10 29.1 33.2 36.0 36.8 -10 23.7 28.2 30.9 32.9 -10 5.4 5.0 5.1 3.9

-15 27.6 31.1 33.3 34.0 -15 22.6 26.3 28.7 30.3 -15 5.1 4.7 4.7 3.7

-25 25.6 28.3 29.8 30.2 -25 21.0 24.0 25.8 26.9 -25 4.6 4.3 4.1 3.2

50 22.5 23.9 24.5 24.4 50 18.7 20.4 21.4 21.9 50 3.9 3.5 3.1 2.5

25 20.2 20.7 20.9 20.6 25 17.1 18.0 18.7 18.8 25 3.1 2.7 2.2 1.8

15 19.3 19.5 19.6 19.2 15 16.5 17.2 17.8 17.6 15 2.8 2.2 1.8 1.5

10 18.8 18.8 18.9 18.5 10 16.2 16.8 17.3 17.1 10 2.6 2.0 1.5 1.4

5 18.3 18.0 18.0 17.8 5 16.0 16.4 16.9 16.4 5 2.3 1.6 1.2 1.4

Euro Stoxx 50 index DAX index

Implied Volatilty Spread (Euro Stoxx 50 - DAX)

Spot: 2,898 Spot: 5,769

11/24/2009

Maturity Maturity Maturity

Delta

1M 3M 6M 12M

Delta

1M 3M 6M 12M

Delta

1M 3M 6M 12M

-5 30.3 33.0 34.8 35.5 -5 27.1 30.3 32.7 34.5 -5 3.2 2.8 2.1 1.0

-10 29.1 30.9 32.1 32.8 -10 26.1 28.3 30.0 31.8 -10 3.0 2.7 2.0 1.1

-15 28.3 29.7 30.4 31.1 -15 25.5 27.1 28.5 29.9 -15 2.9 2.6 1.9 1.2

-25 27.3 28.0 28.3 28.7 -25 24.6 25.7 26.6 27.5 -25 2.7 2.4 1.7 1.2

50 25.8 25.6 25.3 25.2 50 23.5 23.6 23.9 24.2 50 2.3 2.0 1.4 1.0

25 24.7 23.9 23.2 22.8 25 22.6 22.3 22.2 22.2 25 2.0 1.6 1.0 0.6

15 24.1 23.2 22.3 21.9 15 22.2 21.7 21.5 21.4 15 1.9 1.5 0.9 0.5

10 23.8 22.7 21.8 21.3 10 22.0 21.3 21.1 20.9 10 1.8 1.4 0.8 0.4

5 23.3 22.1 21.2 20.6 5 21.7 20.8 20.5 20.3 5 1.7 1.3 0.7 0.2

6


CHANGE IN PROTECTION COST PROVIDES OPPORTUNITIES TO CRYSTALIZE PROFIT AND TARGET BETTER RISK REWARD


0%

50%

100%

150%

200%

80.0% 85.0% 90.0% 95.0%

Risk

Reward

as a

function

of cost

or

expected

potential

losses

(Normalized

by

duration)

Theoritical scenarios (Bump spot and implied volatility)

Risk reward analysis for 3 equivalent 6 months 70% put delta hedge strategies on 3 different

underlyers, as of November 23, 2009

SPX index

SX5E index

DAX index

0%

50%

100%

150%

200%

250%

300%

80.0% 85.0% 90.0% 95.0%

Risk

Reward

as a

function

of cost

or

expected

potential

losses

(Normalized

by

duration)

Theoritical scenarios (Bump spot and implied volatility)

Risk reward analysis for 3 equivalent 6 months 70% put delta hedge strategies on 3 different

underlyers, as of September 29,2010

SPX index

SX5E index

DAX index

7


SCREEN A LARGE UNIVERSE OF UNDERLYERS AND INSTRUMENTS TO MANAGE PORTFOLIO AND ALLOCATION

Source: Capstone, data as of Jan 8, 2015For illustrative purposes only

1234

-100%

100%

300%

500%

700%

900%

1100%

1300%

1500%

Risk Reward by Underlyer

8


HEDGING CHALLENGES


1,250

1,300

1,350

1,400

1,450

1,500

94.0

94.1

94.2

94.3

94.4

94.5

94.6

94.7

94.8

94.9

Dec-11

Jan-12

Feb-12

Mar-1

2

Apr-1

2

May-12

May-12

Jun-12

Jul-1

2

Aug-12

Sep-12

Oct-1

2

Nov-12

Dec-12

Jan-13

S&P 5

00 Index

NAV

Portfolio 1, S&P 500 6 Month 90% Put Option S&P 500 Index

EXAMPLE OF OVERLAY UNDERPERFORMANCE DUE TO PATH DEPENDENCY:NAV performance of 90% put portfolios (1% of NAV is invested in premium every year) and S&P 500 index

On May 31, 2012:

• S&P 500 monthly return is

negative 6.27%

• Portfolio 1 monthly return is

negative 0.09%

• Systematic/always invested

• Path dependency

• Basis risk

• Cost

• Payoff

9


MEASURING COST OF PROTECTION


Cost of Smile

S&P 500 Variance Swap implied strike Vs ATM implied volatility

0

10

20

30

40

50

60

0

1

2

3

4

5

6

7

8

9

10

Dec-01

Dec-02

Dec-03

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Dec-12

Dec-13

Dec-14

At th

e M

oney Im

plied V

ola

tility

Spre

ad in V

ola

tility

Poin

t

Spread(Variance Swap Strike /

ATM Implied Volatility)

ATM Implied Volatility

Where ATM implied volatility was above 22 in

early September 2008, the spread between

variance swap and ATM implied volatility was

decreasing, convexity was at the time trading

cheap to ATM implied volatility

The spread was trading at its

high in November 2008

10

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