Efficient VA Hedging Instruments for Target Volatility Portfolios. Jon Spiegel

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1 Efficient VA Hedging Instruments for Target Volatility Portfolios Jon Spiegel

2 For Institutional Investors Only Not for Retail Distribution Efficient VA Hedging Instruments For Target Volatility Portfolios Jon Spiegel, Director EBIG Conference - Chicago November 14, :30 to 15:00 hours Equity Structuring Global Investment Solutions

3 11/12/2016 9:52:13 AM 2010 DB Blue template Disclaimer (1/2) This presentation is provided for informational purposes only and does not create any legally binding obligations on Securities Inc. and/or its affiliates and Securities Limited (collectively DB ). Without limitation, provision of this presentation does not constitute an offer, an invitation to offer, or a recommendation to enter into any transaction or to take any action on your part. The presentation does not constitute investment advice and DB is not acting in a fiduciary capacity with respect to you or any other party. Before entering into any transaction or making any investment decision you should take steps to ensure that you fully understand appropriateness of the action in the light of your own objectives and circumstances. You should consider seeking advice from your own advisers in making this or any other assessment, including professional tax, legal, accounting and other advisors. If after making your own assessment ywou independently decide you would like to pursue a specific transaction with DB there will be separate offering or other legal documentation the terms of which will (if agreed) supersede any indicative and summary terms contained in this document. BEFORE ENTERING INTO ANY TRANSACTION YOU SHOULD TAKE STEPS TO ENSURE THAT YOU UNDERSTAND AND HAVE MADE AN INDEPENDENT ASSESSMENT OF THE APPROPRIATENESS OF THE TRANSACTION IN LIGHT OF YOUR OWN OBJECTIVES AND CIRCUMSTANCES, INCLUDING THE POSSIBLE RISKS AND BENEFITS OF ENTERING INTO SUCH TRANSACTION. YOU SHOULD ALSO CONSIDER MAKING SUCH INDEPENDENT INVESTIGATIONS AS YOU CONSIDER NECESSARY OR APPROPRIATE FOR SUCH PURPOSE. The presentation is based on material DB believes to be reliable; however, DB does not represent that the presentation is accurate, current, complete, or error free. Any assumptions, estimates and opinions contained in the presentation constitute DB s judgment as of the date of the material and are subject to change without notice. DB reserves the right, at any time and without notice, to discontinue making the presentation available. The presentation may not be reproduced or distributed, in whole or in part, without the DB s express prior written approval. Any quantitative models, processes and parameters are subject to amendment, modification, adjustment and correction at DB s discretion, and may incorporate DB s qualitative judgment. DB will from time-to-time run or update any such models at its sole discretion. The past performance of any securities, indexes or other instruments referred to herein does not guarantee or predict future performance. Please note that any market values provided may be affected by a number of factors including index values, interest rates, volatility, time to maturity, dividend yields and issuer credit ratings. Any calculations of returns on instruments referred to herein may be linked to a referenced index or interest rate. In such cases, the investments may not be suitable for persons unfamiliar with such index or interest rate, or unwilling or unable to bear the risks associated with the transaction. Any products denominated in a currency, other than the investor s home currency, will be subject to changes in exchange rates, which may have an adverse effect on the value, price or income return of the products. These products may not be readily realizable investments and / or not traded on any regulated market. Any securities referred to herein involve risk, which may include interest rate, index, currency, credit, political, liquidity, time value, commodity and market risk and is not suitable for all investors. 1

4 11/12/2016 9:52:13 AM 2010 DB Blue template Disclaimer (2/2) This communication was prepared solely in connection with the provision of information related to the transaction or matter addressed herein, and was not intended or written to be used, and cannot be used or relied upon, by any taxpayer for purposes of avoiding any U.S. federal income tax penalties. The recipient of this communication should seek advice from an independent tax advisor regarding any tax matters addressed herein based on its particular circumstances. Any prices or terms contained in the presentation are indicative and represent an indication of the prices or terms at which DB might have paid or charged, as of the time and date specified. Any prices do not represent a firm bid or offer on the part of DB. Firm bid/offer prices can only be obtained on a real-time, expressly agreed upon, basis. Any indicative prices may differ substantially from a firm bid/offer. Any indicative prices do not necessarily reflect DB s internal bookkeeping or theoretical data-based valuations. Certain factors which may not have been assessed for purposes of these indicative prices, including, notional amounts, spreads, underlying volatility, costs of carry or use of capital and profit, may substantially affect a stated indicative price. Any indicative prices obtained from the presentation may vary significantly from valuations available from other sources. Accordingly, under no circumstances should you use the presentation for purposes of valuing your own books and records. DB or its affiliates or persons associated with DB or such affiliates may maintain a long or short position in securities or other financial instruments referred to herein, or in related futures or options, purchase or sell, make a market in, or engage in any other transaction involving such securities or other financial instruments, and earn brokerage or other compensation. Securities and investment banking activities in the United States are performed by Securities Inc., member NYSE, FINRA, NFA and SIPC, and its broker-dealer affiliates. These instruments are not insured by the Federal Deposit Insurance Corporation (FDIC) or any other U.S. governmental agency. Securities activities in Canada are performed by Securities Limited, a Member of the Canadian Investor Protection Fund. These instruments are not deposit liabilities of and are not insured by the Canada Deposit Insurance Corporation. The distribution of this document and availability of these products and services in certain jurisdictions may be restricted by law DB HEREBY SPECIFICALLY DISCLAIMS ALL LIABILITY FOR DIRECT, INDIRECT, CONSEQUENTIAL OR OTHER LOSSES OR DAMAGES, INCLUDING, BUT NOT LIMITED TO, LOSS OF PROFITS, THAT MAY ARISE FROM ANY RELIANCE ON THE PRESENTATION, OR FOR THE RELIABILITY, ACCURACY, COMPLETENESS OR TIMELINESS THEREOF, OR FOR ANY DELAYS OR ERRORS IN THE TRANSMISSION OR DELIVERY OF THE PRESENTATION. 2

5 11/12/2016 9:52:13 AM 2010 DB Blue template Efficient VA Hedging Instruments For Target Volatility Portfolios Agenda 1 Target Volatility Risk Properties 2 Target Volatility Puts vs. Vanillas 3 Other Tactical Hedging Instruments 3

6 11/12/2016 9:52:13 AM 2010 DB Blue template Target Volatility Risk Properties Introduction Over the past five years, the AUM of VA managed volatility funds has grown to over $200bn 1 Target volatility strategies are likely to exhibit long-term volatilities close to their targets, neutralizing the vega exposure of VA guarantees However instantaneous equity risk scenarios still show significant crash-risk. Hedge with vanillas? (1) Source: DB Equity Derivatives Research 4

7 11/12/2016 9:52:10 AM 2010 DB Blue template Target Volatility Risk Properties Example: S&P 500 Risk Control Indices SPXT10UT SPXT15UT SPXT Source: Bloomberg Finance L.P. and DB Structuring 5

8 Target Volatility Risk Properties Realized Volatility (1yr) 5 45% 4 35% 3 25% 2 15% 1 5% SPXT10UT SPXT15UT SPXT SPXT10UT-Avg SPXT15UT-Avg SPXT-Avg Source: Bloomberg Finance L.P. and DB Structuring 6

9 Target Volatility Risk Properties Realized Skew: Realized Volatility vs. Returns (Semi-annual, Dec 99 Jun 16) 6 SPXT10UT 6m Realized Vol SPXT15UT SPXT y = -0.51x y = -0.02x y = -0.11x m Return Source: Bloomberg Finance L.P. and DB Structuring 7

10 Target Volatility Risk Properties Historical SPX Implied Volatility vs. Subsequent Realized (12/31/1999 5/10/2016) SPX 6m ATM Implied Vol SPX 6m 9 Implied Vol Subsequent 6m Realized Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research 8

11 Target Volatility Risk Properties SPX 6m Implied vs. Subsequent Realized Spread (12/31/1999 5/10/2016) 3 ATM Implied - Realized 2 9 Implied - Realized Strike Avg Since Dec 99 Avg Since Jan % 8.07% % Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research 9

12 11/12/2016 9:52:17 AM 2010 DB Blue template Target Volatility Puts vs. Vanillas Introduction Intuitively it should be more efficient to hedge liabilities linked to target volatility funds using puts on target volatility indices to avoid overpaying for implied volatility and skew We compare the performance of hypothetical target volatility puts with the performance of comparable listed options Caveats: (1) The target vol index is a systematic proxy for portfolios which generally contain discretionary funds with diverse mandates (2) Target volatility puts are not widely traded, so pricing is hypothetical 10

13 11/12/2016 9:52:17 AM 2010 DB Blue template Target Volatility Puts vs. Vanillas Comparable Instruments Methodology We compare the PL from buying puts on target volatility indices with the PL from buying comparable vanilla puts, for each trade date Comparing target volatility puts with vanilla equity puts requires careful consideration as the vanilla equity put embedded in a TV put has changing notional and strike over the life of the trade We adjust the vanilla strike and notional to have equivalent intrinsic value on trade date for all equity scenarios ( equal crash protection ) Dynamic Adjustment: Compare TV put to scaled vanilla put adjusted using most recent TV Participation Static Adjustment: Compare TV put to scaled vanilla put using fixed long-term average TV Participation 11

14 11/12/2016 9:52:17 AM 2010 DB Blue template Target Volatility Puts vs. Vanillas Comparable Instruments Adjustment Vanilla Notional TV Notional TV Participat ion % Vanilla Strike 100 % 1 TV Strike TV Participat % ion % Strike (e.g. 95%) Notional Adjustment Equity Allocation Target Volatility Index Strike Adjustment Cash Allocation (not to scale) 12

15 11/12/2016 9:54:44 AM 2010 DB Blue template Target Volatility Puts vs. Vanillas Back-test methodology for TV 1 6m 95% Put, Dynamically Adjusted Select Listed Expiration For each trading day, locate SPX listed expiration closest to 6 months Select Scaled Vanilla Strike For selected expiration, locate strike closest to participation-adjusted TV equivalent Example: 7 participation 1-.05/.7 = 92.85% Adjust TV Tenor and Strike Adjust TV tenor and strike slightly to correspond with listed option used for scaled vanilla Price TV and Vanilla Puts 1 TV 6m 95% put BS: vol, fwd = libor flat 1 TV 12m 9 put BS: vol, fwd = libor flat Scaled Vanilla Listed mid-market (1) Indicative and hypothetical 13

16 Target Volatility Puts vs. Vanillas SPXT10UT 6m 95%; Dynamic Adjustment Average Price and Payoff by Trade Date Year 6% 4% Target Vol Price Target Vol Payoff 2% 6% 4% 2% Scaled Vanilla Price Scaled Vanilla Payoff Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research 14

17 Target Volatility Puts vs. Vanillas SPXT10UT 6m 95%; Dynamic Adjustment PL by Trade Date (Jan 00 Oct 16 1 ) 15% 1 5% -5% -1-15% Scaled Vanilla PL Target Vol PL TV - Scaled Vanilla Trade Date (1) Assuming that options unexpired as of Nov 11, 2016 expire OTM Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research 15

18 Target Volatility Puts vs. Vanillas SPXT10UT 6m 95%; Dynamic Adjustment PL by Trade Date (Since ) 5% 4% 3% 2% 1% -1% -2% -3% -4% -5% Scaled Vanilla PL Target Vol PL TV - Scaled Vanilla Trade Date (1) Assuming that options unexpired as of Nov 11, 2016 expire OTM Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research 16

19 Target Volatility Puts vs. Vanillas Target Vol Behavior in Different Sell-Offs 10 5 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun Participation (RHS) SPXT10UT SPXT Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Participation (RHS) SPXT10UT SPXT Source: DB Structuring, Bloomberg Source: Bloomberg Finance L.P. and DB Structuring 17

20 Target Volatility Puts vs. Vanillas SPXT10UT 6m 95%; Dynamic Adjustment Target Vol Put vs. Scaled Vanilla PL, Average by Trade Year 5% -5% 2 15% 1 5% -5% -1-15% % 0.7% -0.8% 0.3% 0.9% 0.7% 0.7% 0.3% TV - Scaled Vanilla PL SPX Return SPXT10UT Return -3.6% % % 0.7% 0.9% 0.8% 0.6% Since 2000 Since % (0.5 p.a.) 0.67% (1.34% p.a.) Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research 18

21 Target Volatility Puts vs. Vanillas SPXT10UT 12m 9; Dynamic Adjustment Target Vol Put vs. Scaled Vanilla PL, Average by Trade Year 5% -5% 2-0.3% 0.5% -0.5% 1.5% 0.5% 1.2% 1.1% -0.8% TV - Scaled Vanilla PL -3.8% 0.1% 1.1% % 1.5% 1.7% Since % p.a. Since % p.a % 1 5% -5% -1 SPX Return -15% SPXT10UT Return -2 Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research 19

22 Target Volatility Puts vs. Vanillas Comparable Instruments Methodology We assume that the liability s equity exposure matches the proxy index. But comparing to the vanilla, does a daily dynamic participation adjustment fairly capture equal crash risk? Hedging with vanillas, as participation increases (decreases) would need to buy (sell) puts to hedge crash risk of target vol liability. IE, buy when vol is falling, sell when vol is rising In another comparison we adjust each vanilla put strike and notional using the same long-term participation of 67% SPXT10UT Participation Average = 67% Source: Bloomberg Finance L.P. and DB Structuring 20

23 Target Volatility Puts vs. Vanillas Back-tested PL Comparison 6m 95% Static (67% Participation) Target Vol Put vs. Scaled Vanilla PL, Average by Trade Year % -0.7% -0.1% -0.4% 0.8% 0.2% -0.1% -0.1% -0.3% TV - Scaled Vanilla PL -5.3% 2.4% 1.3% 2.1% 0.7% 1.1% 0.4% % Since % (0.28% p.a.) Since (2. p.a.) 1 5% -5% -1-15% -2 SPX Return SPXT10UT Return Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research 21

24 Target Volatility Puts vs. Vanillas Dynamic vs. Static Hedging with Vanillas 8% Participation (RHS) Scaled Vanilla PL, Dynamic Scaled Vanilla PL, Static 6% % 2% Dynamic buys less, puts expire ITM Dynamic buys less, puts expire OTM 8 6-2% -4% -6% Dynamic buys more, puts expire OTM 4 2 Source: Bloomberg Finance L.P., DB Structuring and DB Equity Derivatives Research 22

25 11/12/2016 9:52:18 AM 2010 DB Blue template Other Tactical Hedging Instruments 1x2 Put Spread Finance tail risk protection by selling ATM gamma Conditional Up- Variance Swap Monetize skew to buy cheap vega, plus 1- day gap protection Variance KO Put Monetize vol and skew with limited risk 23

26 11/12/2016 9:52:20 AM 2010 DB Blue template Delta-Hedged 1x2 Put Spread Using vanilla options, VA hedgers can set up a position that provides: Positive carry Long skew, Long convexity, Deep tail risk protection The strategy entails: Selling an ATM or near-atm put Buying 2 OTM puts Delta hedging In return for the above benefits, seller is exposed to high implied or realized volatility without a significant selloff in spot Applicability: Target vol liabilities may incur less daily delta hedging than traditional VA and would be better positioned to sell local gamma 24

27 Delta-Hedged 1x2 Put Spread SPX 6m, Delta-based strikes Indicative PL Back-test: Sell $1/6 notional every month 14% 12% 1 8% 6% 50d/5d 4% 50d/10d 2% SPX (RHS) -2% 2,500 2,000 1,500 1, Source: Bloomberg Finance L.P. and DB Structuring 25

28 Delta-Hedged 1x2 Put Spread SPX 6m, Delta-based strikes Strikes Back-test SPX 50d Avg Strike 5d Avg Strike 10d Avg Strike Source: Bloomberg Finance L.P. and DB Structuring 26

29 Delta-Hedged 1x2 Put Spread SPX 6m, Delta-based strikes Gamma Back-test 0.6% 0.4% 0.2% % -0.4% -0.6% -0.8% d/5d 50d/10d SPX (RHS) 2,500 2,000 1,500 1, Source: Bloomberg Finance L.P. and DB Structuring 27

30 Delta-Hedged 1x2 Put Spread SPX 6m, Delta-based strikes Vega Back-test 0.25% % % % % d/5d 50d/10d SPX (RHS) 2,500 2,000 1,500 1, Source: Bloomberg Finance L.P. and DB Structuring 28

31 11/12/2016 9:52:20 AM 2010 DB Blue template Conditional Up-Variance Swap Conditional Up-Variance Swaps only accrue variance if the spot price is above a barrier. Applicability: Use ITM (downside) barrier; Provide 1-day gap protection as barrier is observed t-1; Best for portfolios requiring some long vega exposure Payoff Notional OccurenceR atio (UpVarStri ke - UpVarReali zed) UpVarReali zed 252 t N t 1 P ln P t N t 1 ind t t -1 ( P 2 t 1 ind ) ( P t 1 ) OccurenceR atio t N t 1 ind N ( P t ) 1 ind(p t-1 ) equals 0 if spot at t 1 is above barrier, otherwise equal to 1 N is expected number of trading days from Trade to Expiration 29

32 Conditional Up-Variance Swap Given steep skew, up-variance strikes are lower than regular variance Average Spread = Indicative SPX 6m Up-Var Strike Indicative SPX 6m Var Strike Barrier = 25% delta put strike (RHS) 94% 92% 9 88% 86% 84% 82% 8 78% 76% (1) Hypothetical back-test Source: DB Structuring Trade Date 30

33 Conditional Up-Variance Swap Realized Conditional Variance and Occurrence Ratio Realized 6m Var Realized 6m Up-Var Occurrence Ratio (RHS) Source: Bloomberg Finance, LP and DB Structuring Trade Date 31

34 11/12/ :00:42 AM 2010 DB Blue template Conditional Up-Variance Swap Except for Trades done in 2008, Up-Var generally would have outperformed regular Var m Var PL 6m Up-Var PL (Equal Var Notional) Average Spread =.44 1 vols Since 2009 = vols (1) Hypothetical back-test Source: Bloomberg Finance, LP and DB Structuring Trade Date 32

35 Conditional Up-Variance Swap Vega scenarios (6m, 92% barrier) Regular Var Vega Upvar Vega Source: Bloomberg Finance, LP and DB Structuring Spot % of Initial 33

36 11/12/2016 9:52:32 AM 2010 DB Blue template Variance Knock-Out Put A Variance Knock-Out Put pays zero if the realized variance surpasses a budget during the life of the trade. Otherwise it pays the same as a vanilla. Applicability: Typically traded by hedge funds. Structure is short-vega and skew, with limited liability. Target volatility hedgers may be positioned to sell vega and skew opportunistically Example: Underlying: Tenor: SPX 6m Realized Variance t t ln S PX S PX i 1 i 1 i 2 Strike: ATM Spot Variance Budget: (Implied Variance)^2 * 0.5 Implied Variance: 0.19 Indicative Cost: 1.3% (72% discount to Vanilla) Vanilla 6m ATM Put: 4.6% 34

37 11/12/2016 9:52:32 AM 2010 DB Blue template Variance Knock-Out Put Implied skew and convexity premia cause the VKO to price the survival rate lower than statistically observed Most negative SPX Returns Avg SPX Return Survival Rate Avg VKO Px/ Vanilla Px 1 to 5% % % 5% to % 22.9% 28.4% 1 to 15% -7.89% 54.3% 28.4% 15% to % 65.7% 28.8% 2 to 25% -2.35% 46.2% 29.1% 25% to % 81.9% 29.5% 3 to 35% 1.78% 89.5% 35.9% 35% to % 94.3% 33.2% Quantile Analysis: SPX 6m ATM VKO; barrier = 6m SPX implied variance on trade date Trade Dates Jan 08 to Apr 16 (1) Hypothetically back-tested Source: Bloomberg Finance L.P and DB Structuring 35

38 Variance Knock-Out Put Vega Evolution: SPX 6m ATM VKO (19.4% budget) Back-Tested from 10/30/ % % % % 0. Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Source: VKO Price SPX (Right) 0.2% 0.1% % -0.2% -0.3% -0.4% -0.5% VKO Vega Vol MTM of Varswap (Right) -0.6% Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Bloomberg Finance L.P and DB Structuring % 21% 19% 17% 15% 36

39 11/12/2016 9:52:33 AM 2010 DB Blue template Final Thoughts Target volatility strategies exhibit less skew as well as more predictable volatility than pure equity. Hedging strategies should benefit from both of these characteristics. Buying puts on TV Indices may provide crash protection with less risk premium cost. Light Exotics such as Conditional Variance and VKO s can monetize expensive skew. Ongoing work: -- Assessing tracking error of VA Portfolios vs. TV Indices. Designing custom benchmarks where appropriate -- Price discovery for Target Volatility Puts -- Portfolio diversification from trading combinations of these instruments 37

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