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Schaeffer's Media Outtake: Thoughts on Hedging, Volatility

Will growth in hedging drive up premiums?

by 11/19/2009 4:15:00 PM
Stocks quoted in this article:

"Standard & Poor's, the world's leading index provider, announced today the launch of the S&P 500 Dynamic VEQTOR Index which dynamically allocates between equity, volatility and cash to provide broad equity market exposure with an implied volatility hedge. 'Implied equity volatility typically has a strong negative correlation to equity market returns, and is considered a useful tool to hedge against the potential downside risk of the broad equity market,' says Liz Taxin, Director of Strategy Indices for S&P Indices. The S&P 500 Dynamic VEQTOR Index is comprised of three components: Equity, as represented by the S&P 500; Volatility, as represented by the S&P 500 Short-Term VIX Futures Index; and Cash, as represented by the Overnight LIBOR rate. The Index allocates between equity and volatility based on the combination of realized and implied volatility trend decision variables, and these allocations are evaluated on a daily basis."
(PR newswire – 11/18/09)

Schaeffer's addendum: So Standard & Poor's is going to be able to successfully determine: 1. When it's a good time to be heavily invested in equities, and when it's not, and 2. Whether the non-equity balance should be invested in "volatility" or in cash. I say "Good luck with that" to their "Director of Strategy Indices."

But another thought occurs. With the enormous growth in volume and open interest in such volatility-based derivatives as the CBOE's VIX options, in conjunction with the growing appetite for hedging volatility, will this result in a period of:

  1. Overpriced options? The logical hedging mechanism for those selling VIX call positions and/or VIX futures positions to meet the demand from hedgers would be long S&P put positions. So this process would tend to drive up the premiums on index puts, which would have a spillover effect in driving up index call premium as well as the premium on equity options.
  2. Fewer "black swans"? This would be based on the theory that when many players insure against a particular scenario, it will tend not to occur. So perhaps on a major market dive, volatility (in the form of the VIX) would not climb nearly to the degree that was expected.

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