Portfolio Hedging with Interest Rate Volatility

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1 Portfolio Hedging with Interest Rate Volatility CBOE RMC USA, 5 March 2015 Presented by Yoshiki Obayashi, Managing Director, Applied Academics LLC In collaboration with Prof. Antonio Mele, Swiss Finance Institute and CEPR 1

2 THE RICH WORLD OF FIXED INCOME VOLATILITY Realized(Vola+li+es((1(month(rolling)( 140" 120" USSW10" CDX" EDA" SPX" TYA"(right"axis)" 20" 18" 16" 100" 14" 80" 12" 10" 60" 8" 40" 6" 4" 20" 2" 0" 1/31/05" 3/31/05" 5/31/05" 7/31/05" 9/30/05" 11/30/05" 1/31/06" 3/31/06" 5/31/06" 7/31/06" 9/30/06" 11/30/06" 1/31/07" 3/31/07" 5/31/07" 7/31/07" 9/30/07" 11/30/07" 1/31/08" 3/31/08" 5/31/08" 7/31/08" 9/30/08" 11/30/08" 1/31/09" 3/31/09" 5/31/09" 7/31/09" 9/30/09" 11/30/09" 1/31/10" 3/31/10" 5/31/10" 7/31/10" 9/30/10" 11/30/10" 1/31/11" 3/31/11" 5/31/11" 7/31/11" 9/30/11" 11/30/11" 1/31/12" 3/31/12" 5/31/12" 7/31/12" 9/30/12" 11/30/12" 1/31/13" 3/31/13" 5/31/13" 7/31/13" 9/30/13" 0" Equity market volatility alone cannot describe uncertainty in the financial markets at large Hedging properties of VIX have been well-studied; what about those of interest rate volatility? 2

3 OPTION-IMPLIED VOLATILITY INDEXES 300" 90" 250" 200" CBOE"SRVX" BAML"MOVE" CS"CIRVE" CBOE"VIX"(right"axis)" CBOE"VXTYN"(right"axis)" 80" 70" 60" Normal)Vol)(bps)) 150" 50" 40" Lognormal)Vol)(%)) 100" 30" 20" 50" 10" 0" 1/2/03" 1/2/04" 1/2/05" 1/2/06" 1/2/07" 1/2/08" 1/2/09" 1/2/10" 1/2/11" 1/2/12" 1/2/13" 1/2/14" 0" Interest rate volatility measures take on different forms: price vs. yield & percent vs. basis point CBOE s unified volatility indexing methodology based on model-free variance swap pricing 3

4 CBOE VXTYN AT A GLANCE Index: CBOE/CBOT 10-year US Treasury Note Volatility Index Formula: Launch Date: May 2013 by Chicago Board Options Exchange Horizon and underlying tenor: Rolling 30-day forward on 10y T-Note futures Skew Points: All calls and puts with non-zero bids, except for those outside of two consecutive zero bids Data Sources: CBOT / CME Globex Publication: VXTYN Index <GO> on Bloomberg 4

5 DYNAMICS BETWEEN EQUITY AND RATES VOL 90" 16" 80" 70" VIX" VXTYN" 14" 12" 60" 50" 40" 10" 8" 30" 6" 20" 4" 10" 2" 0" 0" 1/1/03" 1/1/04" 1/1/05" 1/1/06" 1/1/07" 1/1/08" 1/1/09" 1/1/10" 1/1/11" 1/1/12" 1/1/13" 1/1/14" 1/1/15" Equity and interest rate volatilities react to different risk factors VXTYN has been jumpier than VIX since QE taper talk began 5

6 VXTYN AND BOND PORTFOLIO RETURNS Relationship between VXTYN and a diversified bond portfolio appears to strengthen in times of heightened concern specifically about the interest rate component of portfolio returns VIX appears to possess marginal explanatory power for other bond return factors 6

7 IF ONE COULD HEDGE WITH VXTYN INDEX RETURNS A naïve beta-weighted hedging strategy using returns on VXTYN index levels kicks in during major drawdowns to smooth bond portfolio returns During the same period, VIX has little to say about AGG 7

8 THE OPPOSITE HOLDS FOR S&P 500 A naïve beta-weighted hedging strategy using returns on VIX index levels kicks in during major drawdowns to smooth equity portfolio returns During the same period, VXTYN has little to say about SPX 8

9 BUT CHANGES IN INDEX LEVELS AREN T TRADABLE The S&P 500 volatility term structure is generally in contango The persistent roll-down of VIX futures makes naïve hedging strategies costly What might we expect for VXTYN futures? 9

10 NO-ARBITRAGE MODEL OF VXTYN FUTURES Mele, Obayashi, and Yang (2014) derive a no-arbitrage model of VXTYN futures and options Model parameters may be calibrated to the: level of VXTYN and the term structure of Treasury yields times series properties of realized TY volatility (levels, variation, and mean-reversion) term structure dynamics of option-implied TY volatility 10

11 HEDGING WITH CALIBRATED VXTYN FUTURES Simulated hedging returns display an upward drift from a roll-up effect and perform even better than hedging with cash index returns Too good to be true? Let s take a look at market prices since VXTYN futures listing in Nov

12 THE PREDICTED BACKWARDATION IS REALIZED The front month contract started off in contango, then entered backwardation Most of the VXTYN futures term structure has been priced below the index level so far this year 12

13 TERM STRUCTURE DYNAMICS THROUGH TIME Market-observed VXTYN futures term structure has taken various shapes in a short period 13

14 FUTURE RESEARCH Devise more sophisticated hedging strategies based on VXTYN futures Explore portfolio hedging strategies using both VIX and VXTYN derivatives Research yield enhancement strategies based on VXTYN derivatives Implement a 3-factor model calibration for pricing VXTYN futures and options Contact: yoshiki.obayashi@appliedacademics.com Data Sources: CBOE and Bloomberg Important Disclaimer: The information contained in this presentationis provided foreducational purposes only, and doesnotconstituteinvestment, securities or trading advice. 14