Is Volatility an Efficient Hedge
Derivatives-based Portfolio Solutions
VOLATILITY HAS UP TO A NEGATIVE 0.70 CORRELATION WITH EQUITY
Equity markets tend to become more volatile when they decline and less volatile when they rise. A fundamental reason for this is the fact that gearing increases as equities decline. As both gearing and volatility are measures of risk, they should be correlated; hence, they are negatively correlated to equity returns. More detailed arguments about the link between equity and volatility are provided in our Capital Structure Arbitrage section. While short term measures of volatility (i.e. vStoxx) only have an R2 of 0.5 to 0.6 against the equity market, longer dated variance swaps (purest way to trade volatility) can have up to a 0.70 R2.
VOL RETURNS MOST CORRELATED TO EQUITY FOR 1-YEAR MATURITY
There are two competing factors to the optimum maturity for a volatility hedge. The longer the maturity, the more likely the prolonged period of volatility will be due to a decline in the market. This should give longer maturities higher equity volatility correlation, as the impact of short-term noise is reduced. However, for long maturities (years), there is a significant chance that the equity market will recover from any downturn, reducing equity volatility correlation. The optimum correlation between the SX5E and variance swaps, is for returns between nine months and one year. This is roughly in line with the stylized fact that it takes approx. 8 months for realized volatility to mean revert after a crisis.
SHORT-DATED VOLATILITY INDEX FUTURES ARE A POOR HEDGE
Recently, there have been several products based on rolling VIX or vStoxx futures whose average maturity is kept constant. As these products have to continually buy far-dated futures and sell near-dated futures (to keep average maturity constant as time passes), returns suffer from upward sloping term structure. Since the launch of vStoxx futures, rolling one-month vStoxx futures have had negative returns, and this despite the fact that the SX5E posted negative performance over the period; suggesting that rolling vStoxx futures are a poor hedge. For more details on futures on volatility indices, see the section Forward Start Products.
LONG VOLATILITY HAS NEGATIVE RETURNS ON AVERAGE
Long volatility strategies, on average, have negative returns. This overpricing can be broken down into two components:
VOLATILITY IS A POOR HEDGE COMPARED TO FUTURES
While all hedging instruments can be expected to have a cost (due to being implicitly short equities and assuming a positive equity risk premium), long variance swaps have historically had an additional cost due to the overpricing of volatility. This additional cost makes long variance swaps an unattractive hedge compared to reducing the position (or shorting futures).
Long volatility hedge suffers from vol. richness, and imperfect negative correlation
While the risk of the long equity and long variance swap position initially decreases as the long variance position increases in size, the returns of the portfolio are less than the returns for a reduced equity position of the same risk (we assume the proceeds from the equity sale are invested in the risk-free rate, which should give similar returns to hedging via short futures). Unlike hedging with futures, there comes a point at which increasing variance swap exposure does not reduce risk (and, in fact, increases it) due to the imperfect negative correlation to the equity market.
Hedging strategies back-testing period needs to have positive equity returns
While we acknowledge that there are periods of time in which a long volatility position is a profitable hedge, these tend to occur when equity returns are negative (and short futures are usually a better hedge). We believe that the best back-testing periods for comparing hedging strategies are those in which equities have a return above the risk-free rate (if returns below the risk-free rate are expected, then investors should switch allocation away from equities into risk-free debt). For these back-testing periods, long volatility strategies struggle to demonstrate value as a useful hedging instrument. Hence, we see little reason for investors to hedge with variance swaps rather than futures given the overpricing of volatility, and less than perfect negative correlation between volatility and equity returns.
HEDGING WITH VARIANCE SHOULD NOT BE COMPARED TO PUTS
Due to the lack of convexity of a variance swap hedge, we believe it is best to compare long variance hedges to hedging with futures rather than hedging with puts. Although variance hedges might be cheaper than put hedges, the lack of convexity for long volatility makes this an unfair comparison, in our view.
Is Volatility an Efficient Hedge?
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