Derivatives Roundup: Volatility Trading – Is it the Holy Grail?

Could it be that the Holy Grail has been spotted at the recent Chicago Board Options Exchange (CBOE) Risk Management Conference? Well not quite, but there was much discussion about what I believe to be the most significant development of my 30-year investment career: volatility trading.

Volatility trading is something every investment professional must know and understand. This is due to the negative correlation between volatility indexes such as the CBOE Volatility Index (VIX) and stock prices. When properly used, the VIX futures and options offer unique hedging opportunities previously unavailable in the marketplace. There are important intricacies with volatility derivatives that investors must be aware of. All of us need to follow the development of these valuable hedging instruments as the marketplace figures out how best to use them.

Elsewhere this month, the Commodity Futures Trading Commission’s Bart Chilton contended that cost-benefit analysis of recent regulatory initiatives is becoming a scapegoat for delaying rule implementation and that Wall Street is now “bastardizing” the regulatory rule-making process. Industry trade groups shot back, arguing that the whole rule-making process was flawed by preventing interested parties from participating meaningfully and that position limits were created before determining whether they were actually needed. These discussions will surely continue in the months ahead.

Many of my Twitter followers missed my veiled connection between Roy Rogers’s Trigger and the Greek debt trigger, but this important story related to the ruling by the International Swaps and Derivatives Association (ISDA) that a credit event had indeed been triggered by the Greek debt restructuring. This ruling caused massive payouts on credit default swap contracts that were used to protect investors from just such an event. It seems to me that the market worked as it should have. (By the way, Trigger was the name of Roy Rogers’s horse, and if you don’t know who Roy Rogers is — well, happy trails to you!)

Finally, there’s an interesting working paper from the Bank for International Settlements that is worth noting: the paper asserts that major derivatives dealers will have adequate margin capital when standardized over-the-counter (OTC) derivatives must be cleared through central counterparties (CCP) later this year. The paper, “Collateral Requirements for Mandatory Central Clearing of OTC Derivatives,” further states that additional capital may need to be raised to meet the variation margin calls that arise if derivatives positions become unprofitable for the owner. In addition, the study finds that concentrating clearing in a single CCP may be particularly efficient while not undermining the robustness of the clearing operations; this was a point of contention in previous discussions on centralized clearing.

For more news and trends, visit the Derivatives Community of Practice.