By Ronan Cosgrave
At the recent Global Volatility Summit in New York, it was abundantly clear to me that there were two competing forces with regard to volatility among those in attendance: Firstly, large institutional pension funds many of whom are selling volatility; and secondly large hedge funds doing complex relative-value trades trying to stay neutral to volatility, or trying to get long volatility and convexity for free.
Given that group one was also potentially the clients of group two, I started to wonder can both co-exist and somehow be right? Or are they opposing forces in a zero- sum game? Well no, because there is a third silent group in the room: indiscriminate volatility/protection buyers. Well obviously they have to be the losers, right? Not necessarily… In order of price insensitivity for volatility, the hierarchy is: 1. volatility buyers; 2. volatility sellers; 3. relative- value traders.
Volatility buyers
Volatility buyers are purchasers of insurance, they pay a premium now to mitigate a possible loss sometime in the future. The purchase of portfolio insurance is not a profit centre and most investors who buy portfolio insurance generally write-off the cost immediately (just like paying your car insurance premium). In the real (non-financial) world, there are no business models—or at least any legal ones—that aim to profit from the simple purchase of and claiming of insurance.
Volatility sellers
Volatility sellers are providers of insurance. They are well aware of the risks of their trades and expect, over time, to be compensated for the act of providing insurance. There is a good reason that insurance companies are enormously large and profitable entities – people are generally willing to over-pay for insurance and security from disaster. Equally, there is a good reason why insurance companies are closely regulated: the temptation can be to sell insurance too cheaply and without reserves to cover losses. So volatility sellers profit from a premium that exists for good reason, but to really make money from selling volatility you can’t rely on being a macro forecaster. If you could forecast crashes accurately, then selling volatility would be the perfect trade: you would just stop selling it before the market falls and then carry on post-fall.
Relative-value traders
Hedge fund managers and other similar relative-value traders sit in between these two massive forces. When two huge pools of money are buying and selling volatility back and forth, a situation is often create in which volatility in one place is priced differently than in another, almost identical, place. The volatility universe is complex and often overlapping, such that traders can usually replicate one instrument using a combination of other instruments. When the price of such an instrument is distorted by heavy buying or selling, relative-value traders may seek to substitute it for a more fairly-priced replication created by combining other instruments or securities. This is because neither the buyer nor the seller really cares about small differences in the price. In the case of the buyer: if traders have written off dollars on the trade, why would they work hard to save a few cents if what they are purchasing is peace of mind? We can probably agree emotional states are impossible to define in monetary terms.
Everyone wins?
As long as there are large pools of price-insensitive capital trading back and forth, opportunities should continue to exist. As long as investors need insurance and security and are willing to overpay for it, markets can maintain a situation in which smart volatility sellers (i.e. large institutional pension funds) are happy to hire relative-value hedge funds to arbitrage themselves and the protection buyers – and in general it’s the protection buyers who pay. But since the value of the transaction they are engaged in is not measured simply by the price, long-volatility players can still be happy since of the three parties in this transaction they are the ones who can be assured of sleeping at night.
Ronan Cosgrave is director and sector specialist for convertible bond hedging at PAAMCO
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