Selective Dispersion

Creating an affordable Long Volatility Exposure in an Equity Portfolio

Assenagon Asset Management S.A.

Contents

1. Single Stocks Volatilities versus Index Volatilities

2. Volatility Flows and their Impact on Correlation
3. How to invest in Dispersion?
4. From a Pair Trade to a Selective Dispersion Portfolio
– Pair Properties
– What about the Skew?
5. Dispersion Portfolio
– An Example
– Cost of Carry
6. A "small" Digression
7. Summary

Contacts
Disclaimer

Assenagon Asset Management S.A. 2

1. Single Stocks Volatilities versus Index Volatilities

 Standard dispersion investment: Trading an index volatility versus the volatility of its components
But where do we stand on a broader scale?
 Volatility Pair Index (VPI)
 (Average implied volatility over 150 stocks worldwide) – (Average implied volatility over 5 main indices worldwide)
 measured ATM forward with a maturity of 270 calendar days
 Value of X%  average single stocks volatility trades X vol.-%-points above our basket of indices
 Current VPI value @ 5.5%
 VPI behaves positively wrt to volatility and offers a decent carry.
How to gain such exposure? Can we further enhance carry and convexity of such a position?
30%
30%
y = 0.2352x + 0.0418
R² = 0.6486
25%

Volatility Pair Index

25%

20%
20%
vol.-%-points

15%
15%

10% 10%

5% 5%

0% 0%
2004 2006 2007 2008 2010 2011 2012 2014 0% 20% 40% 60% 80%
Volatility Pair Index (implied, ATMf, 270d) implied volatility SPX Index (ATMf, 270d)
Volatility Pair Index (realized, 90d)

Source: Assenagon Equity Derivatives Database, Bloomberg

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 2. Volatility Flows and their Impact on Correlation

 Contrarian flows explain distortions in correlation

 On indices
 The protection and hedging flow is focused on liquid indices. Tendency to drive the volatility higher.
 On stocks
 Dealers get long single stocks volatility through the issuance of structured products.
 Dealers books are short vol. convexity  need to sell more volatility in markets with decreasing volatilities
 Overwriting flow for yield enhancement strategies

40%
40% Barrier Options put dealers long volatility:
Implied Single Stock - Selling Down & Out puts
35% 35%
- Reverse Convertible Structures
Volatilities
- Autocallable Structures (Down & In puts)
Tail Hedging
30% 30%

25%
Variable Annuities Implied correlation 25%
increases Overwriting Flow
20%
when index volatility gets
Upside Protection closer to stocks 20%
15%
Implied Index
15%
10% Volatilities

5% 10%
900.00 1300.00 1700.00 2100.00 80.00 130.00 180.00 230.00

Call Bid Call Ask Putl Bid Put Ask Call Bid Call Ask Put Bid Put Ask

Source: Assenagon Equity Derivatives Database

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3. How to invest in Dispersion?

 Main trades offering dispersion exposure for the buyside: A practical perspective.

Fixed Strike Options Variance Swaps Volatility Swaps

Liquid and transparent ++ Low maintenance

++
instruments
++ Self delta hedging
++ Allows for active position Mgmt
++ Constant gamma
-- Path dependency
+/- Vol. convexity ++/-- Mostly the same arguments as
-- Heavy maintenance: daily delta for the variance swap trade
hedging, changing Γ & Ѵ etc… -- Valuation concerns (OTC product)

-- Difficult to track the floating -- Difficult to actively manage the

strike used when analyzing position due to liquidity
the correlation level constraints

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How to invest in Dispersion?

 From an actively managed perspective:

 Instrument that can be frequently traded in & out
 Instrument where valuation can be independently determined

IX Short IX Short
Vol. 1 Vol. 2 Dispersion Exposure is generated Liquidity & Transparency
V+ V+
…
through a sum of Volatility Pair Trades
S1 S2
Var./ Vol. Swap Options
 Actively managing your pairs (profit or loss taking)
 Monitoring carry (realized – implied) on a micro level
 Keeping an optimized dispersion position at any time #1 OTC
Counterpart Listed OTC
+ only Market Market
selected
Transparent
banks
Valuation
quoting …
 Trading fixed strikes options (liquid, listed, transparent
for valuation)
 Trading with some improvements taking into account
the skew dynamics

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4. From a Pair Trade to a Selective Dispersion Portfolio

 In order to get exposure to an optimized version of the "Volatility Pair Index", one can apply a comprehensive screening on all
volatility pairs to detect those with the following properties:
 Long convexity bias
 Minimizing implied draw downs given volatility regimes
 Vega neutral (long/short volatility in the same amount)
 Maximizing carry (realized – implied volatility)
 Diluting the correlation risk
70% 70% 45%
y = 0.83x - 0.0443
40%
GS US – SPX Index (ATMf, 360d)

R² = 0.5759
60% 60%
35%
Convexity
Implied volatility pair

50% 50% 30%

25%
40% 40%
20%
30% 30%
15%

20% 10%
20%
5%
10%
10% 0%
Historical implied floor
0% -5%
0%
0% 10% 20% 30% 40% 50% 60% 2005 2007 2009 2011 2013
implied volatility SPX Index (ATMf, 360d) Carry implied volatility pair GS US - SPX (rhs)
Implied volatility pair GS US - SPX (lhs)
Source: Assenagon Equity Derivatives Database
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4. From a Pair Trade to a Selective Dispersion Portfolio

 One can understand and quantify how each pair reacts to correlation movements
100% 70% 90% 40%
60% 80%
70% 30%

vol.-%-points
Correlation
vol.-%-points
75% 50%
Correlation

60%
20%
40% 50%
50% 40%
30% 10%
30%
25% 20% 20% 0%
10% 10%
0% -10%
0% 0%
2006 2008 2010 2012 2014
2006 2008 2010 2012 2014
SPX 1y realized correlation
SPX 1y realized correlation SPX 1y implied correlation
SPX 1y implied correlation Implied volatility pair SIE GY – DAX Index (ATMf, 1y)
Implied volatility pair GS US – SPX Index (ATMf, 1y)

90% 10%
80% 9%
70% 8%
Correlation

60% 7% vol.-%-points
50% 6%
40% 5%
30% 4%
20% 3%
10% 2%
0% 1%
2006 2008 2010 2012 2014

SPX 1y realized correlation

SPX 1y implied correlation
Implied volatility pair RTY Index – SPX Index (ATMf, 1y)

Source: Assenagon Equity Derivatives Database

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4. From a Pair Trade to a Selective Dispersion Portfolio –
What about the skew?

 Buy Optionality:
 Sell an amount of Δ to compensate the skew effect
 In its magnitude, this Δ is similar to a Variance Swap Δ

40%

35%

30%

25%

20%

15%

10%

5%
900.00 1300.00 1700.00 2100.00
Call Bid Call Ask Putl Bid Put Ask

Volatility Pair Volatility Pair

Long Short
Long Vega
Vega Delta

Short Long
Short Vega
Vega Delta

Source: Assenagon Equity Derivatives Database

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5. Dispersion Portfolio – An example

 With Fixed Strike Options

– Managing the skew effect is essential to mitigate tracking errors
– Residual long Δ (skew difference index vs. stocks)
 Note: variance swap dispersion is showing similar long Δ net exposure

Plain Vanilla Selective Variance Swap Selective 18%

Dispersion Dispersion 16%
Position Additional Δ Position Additional Δ 14%
SPX SPX 12%
-400k USD +7.2M USD -400k USD +5.7M USD 10%
Vega Vega
8%
AFL US -141k USD AFL US -100k USD
6%
BHP US -122k USD BHP US -110k USD
4%
CAT US -115k USD CAT US -100k USD
2%
CMCSA US -89k USD CMCSA US -90k USD 2014 collapse in dispersion levels
0%
CMI US -100k USD CMI US -80k USD 2009 2010 2011 2012 2013
… … … … Selective dispersion (fixed strikes + additional deltas)
Total net Δ +3.9M USD Total net Δ +2.7M USD Volatility Pair Index

Source: Assenagon Equity Derivatives Database

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5. Dispersion Portfolio – Cost of Carry

 Managing the cost of carry in the portfolio is essential for the long-term sustainability of the position.
 Carry is produced through realized volatilities and captured by means of daily delta hedging.
 Despite a challenging year 2014 with shrinking implied levels of dispersion, the carry was a constant source of return.

Selective dispersion in 2014 (net carry) Dispersion Performance YTD

1.40% 8%

1.20%
7%
1.00%

6%
0.80%

0.60% 5%

0.40%
4%
0.20%
3%
0.00% Jan 14 Mar 14 May 14 Jul 14
Jan 14 Mar 14 May 14
Dispersion performance

Dispersion performance + carry

Source: Assenagon Equity Derivatives Database

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6. A "small" Digression

 What is that?  Without a 30 months shift forward in FDFD Index

45 8 45 8

40 7 40 7

35 6 35 6

30 5 30 5

25 4 25 4

20 3 20 3

15 2 15 2

10 1 10 1

5 0 5 0

0 -1 0 -1
Apr 95 Jun 98 Sep 01 Nov 04 Feb 08 Apr 11 Jun 14 Oct 92 May 96 Nov 99 May 03 Dec 06 Jun 10 Jan 14

SPX 360volatility
realized Days Realized Volatility
SPX Index (360d) ? SPX 360 volatility
realized Days Realized Volatility
SPX Index (360d) FDFD index
Index

Source: Bloomberg

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7. Summary

Trading dispersion can offer both long volatility and positive carry

Current dispersion levels are very attractive compared to recent years

Practical implementation can be tricky and cumbersome (but not impossible)

Ensuring liquidity in the dispersion portfolio is crucial

Assenagon Asset Management S.A. 13

Contacts
Customer Coverage
 Hans Günther Bonk
Phone +49 89 519966-410
hans-guenther.bonk@assenagon.com
 Michael Huber
Phone +49 89 519966-452
michael.huber@assenagon.com
 Matthias Kunze
Phone +49 89 519966-421
matthias.kunze@assenagon.com
 Michael van Riesen
Phone +49 89 519966-419
michael.vanriesen@assenagon.com
 Ronald Siebel
Phone +49 89 519966-420
ronald.siebel@assenagon.com
 Marcus Steudner
Phone +49 89 519966-451
marcus.steudner@assenagon.com
Assenagon Asset Management S.A.
Sales Operations
 Simone Alanne
Phone +49 89 519966-460
simone.alanne@assenagon.com
 Carina Herz
Phone +49 89 519966-462 Imprint
carina.herz@assenagon.com
Assenagon Asset Management S.A.
Senior Advisor Aerogolf Center
1B, Heienhaff
 Christian Maria Kreuser
Phone +49 89 519966-378 1736 Senningerberg, Luxemburg
christian-maria.kreuser@assenagon.com Assenagon Asset Management S.A.
Zweigniederlassung München
Chief Economist
Prannerstraße 8
 Dr. Martin W. Hüfner 80333 München, Deutschland
Phone +49 89 519966-150
martin.huefner@assenagon.com Assenagon Schweiz GmbH
Paradeplatz 4
8001 Zürich, Schweiz
Assenagon Client Service GmbH
Prannerstraße 8
80333 München, Deutschland
www.assenagon.com
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Disclaimer

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12 August 2014

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