Volatility indices and OTC derivatives

Volatility indices and OTC derivatives
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First Published: Mon, Nov 22 2010. 09 27 PM IST

Illustration: Shyamal Banerjee/Mint
Illustration: Shyamal Banerjee/Mint
Updated: Mon, Nov 22 2010. 09 27 PM IST
It had seemed that one of the fallouts of the National Stock Exchange’s (NSE) monopoly in the equity derivatives market would be that it would be the only exchange to offer futures and options products on volatility indices. The Securities and Exchange Board of India (Sebi), after all, has stipulated that volatility indices on which derivatives contracts can be introduced need to have a track record of at least one year. NSE had launched its “India VIX” index about three years ago and started disseminating real-time data on the index about four months ago.
Its competitor, Bombay Stock Exchange (BSE), it had seemed, couldn’t launch a similar index because of the lack of liquidity in its index options market. Implied volatility indices such as the India VIX and the CBOE VIX derive their valued from traded option prices.
But interestingly, BSE launched its own volatility index last week, with the Sensex as the underlying asset. Instead of launching an implied volatility index, it has introduced the concept of a realized volatility index in the country. Realized volatility is a statistical measure of the variability of price returns relative to a mean price return, measured as the standard deviation of the daily log returns of an underlying index. Put simply, an implied volatility index provides a measure of expected volatility in the future, while a realized volatility index is a measure of the historical (realized) volatility of the asset.
This isn’t a new concept. The Chicago Board Options Exchange (CBOE), which created the popular VIX index, introduced realized volatility options a little over two years ago. These were exchange-traded options contracts based on the three-month realized, or historical, volatility of the S&P 500 index. With its launch, the exchange said investors would have expanded opportunities to trade both implied and realized volatility measures.
Illustration: Shyamal Banerjee/Mint
But while trading in VIX products is robust, the realized volatility options haven’t done very well. Of course, VIX had a head start, having been launched more than six years ago. And it’s not that there isn’t adequate interest among market participants for derivatives products with realized volatility as the underlying. For years, variance swaps, which allow investors to trade future realized (or historical) volatility with current implied volatility, have been traded in over-the-counter (OTC) markets.
Savvy-option traders write options when they feel that the implied volatility is too high and the future realized (or historical) volatility will be lower. They write options essentially to pocket this difference and hedge their exposure to the price movements in the underlying asset through what is know as delta hedging—effectively taking an opposite position in the futures market. In such strategies, which are a play on volatility, a second level of hedging to offset what is known as gamma risk, can be useful. Derivatives on realized volatility indices help hedge this risk.
BSE’s plans to offer derivatives on realized volatility are, therefore, a welcome addition to India’s financial markets. Having said that, the fact that hardly any derivatives contracts trade on BSE could mean that this product could be a non-starter too.
But considering that derivatives on realized volatility indices are used more in an OTC framework in developed markets, Indian policymakers should look at allowing them as OTC products for our markets as well. Sebi has been talking of OTC derivatives since its infamous ban on participatory notes in late 2007. This was followed by a recommendation by a derivatives market review committee that OTC products should be allowed for equity derivatives. While there are risks associated with OTC derivatives, such as those highlighted in the credit crisis, the Sebi-appointed committee has prescribed adequate safeguards such as compulsory reporting and central clearing of trades through exchanges/clearing corporations.
It’s important to note here that Sebi’s experiment with long-dated options has worked to some extent because of block trades that are negotiated on the phone and then executed on the exchange platform. So even though the product is meant to be an exchange-traded product, for all practical purposes it’s an OTC product, which is reported and cleared by an exchange. A similar model would work for other products as well, with the same risk containment framework.
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First Published: Mon, Nov 22 2010. 09 27 PM IST