US - Derivatives that pensions can use to dampen the long-term volatility of their US equities holdings have hit extremely high levels recently, after US legislation caused extreme supply/demand imbalances.
Hedge funds investing in volatility for profit say the present anomalous levels could persist, providing long-term opportunities for their trading programs.
One hedge fund manager Global Pensions spoke to said some larger US pensions with expertise in the area have been active trading in derivatives linked to volatility, to counteract share price volatility in their own portfolios, while smaller peers have turned to hedge funds to achieve similar ends.
But the prices of such derivatives recently hit levels so high they imply shares in the S&P 500 index will move by over 2% a day until 2020.
A recent daily strategy piece by equity derivatives broker dealer Macro Risk Advisors found the long-dated volatility levels that derivatives' prices imply would not even come from running together the S&P's 2520 most volatile trading days since 1940.
US regulations forcing insurance firms to increase protection against volatility on variable annuity products, coupled with laws that led banks to reduce provision of volatility-linked derivatives drove them to historic highs, said Paul Britton, chief executive of volatility hedge fund Capstone Holdings Group.
Francois Buclez, founding partner at fund of hedge funds Cube Capital, said institutional investor demand would not fade quickly despite the increased volatility. "You will see a lot more of these types of trades because the regulator is clipping the wings of banks, forcing them to retreat from traditional areas where they provided liquidity."
David Rogers, chief executive at relative-value volatility hedge fund JD Capital Management, said simply: "It as an extraordinary anomaly. In my mind, it is hard to see it holding up at these levels."
Hedeer El Showk, risk analyst at fund of fund Signet, added: "It seems clear volatility was a great buy with at least a 3:1 payoff when the Vix (Chicago Board Options Exchange Volatility Index) was at 15 with a small chance of grinding down to 10, and a significant chance of it exploding to 30. Today, with equal chances of it moving back down to 15 or heading to 50, you're looking at a payoff closer to 2:1.
"The flip-side of this is that recent moves have very likely caused dislocations in certain markets that astute volatility managers can take advantage of."
Patric de Gentile Williams, chief operating officer at FRM Capital Advisors, said: "Volatility is an asset class in its own right that has many statistical linkages between instruments in a way that the equity market does not. These create opportunities for arbitrage between instruments which are thrown out of theoretical balance by forces of supply and demand."
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