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A new type of investment instrument offered by the JSE is attracting increased interest from traders on the exchange. Variance futures are exotic (or complex) derivatives allowing investors to profit from volatility in the market or a portfolio, or to insure against it. These instruments are particularly useful at times when analysts anticipate increased movement in the market due to changes in market sentiment.
Increasingly complex investment strategies in a competitive market mean that professional investors are constantly looking for new ways to gain the returns they require. The JSE, recognised for its innovation and creativity in designing new products, is one of the few exchanges in the world that offers variance futures. Launched in early 2010, interest in these exotic products has grown fast during the last quarter, says JSE director Allan Thomson.
“Investors trade these assets for two main reasons,” says Thomson. “They may wish to speculate on changes in volatility in the market directly, without being affected by market direction. In effect, these speculators wish to trade on levels of anxiety in the market. Or they may wish to hedge an option portfolio against unwanted volatility, that is, they may have a view on the market’s future direction and want to trade that, without being impacted by how much the market fluctuates while moving up or down over time.”
Volatility is the rate at which the price of a security moves up and down. If the price of a stock fluctuates rapidly, it has high volatility (and greater risk). If the price almost never changes, it has low volatility. At the JSE, this information is reflected in the South African Volatility Index (SAVI), launched in 2007. Variance measures the price fluctuation of an instrument over a period of time.
It is possible to trade exotic derivatives over the counter (OTC), without going through a stock exchange. When that happens, the derivatives are valued by the traders themselves. Thomson says instruments traded through an exchange have advantages over OTC products. First, valuations are done by an independent third party (the exchange). Second, trading through the JSE eliminates counterparty risk as the exchange has strong risk management processes.
The JSE offers two types of variance futures – standardised variance products, which can currently be traded free of charge, and Can Do variance products, which are tailor made to fit the needs of each client. Can Do’s, unusual products on stock exchanges where mostly standardised products are traded, are the more popular instruments of the variance group. “The derivatives team meets with clients, finds out about their needs based on the portfolios they hold, and structures Can Do products to meet these specific needs,” says Thomson.
Often, holders of Can Do products don’t trade them after entering into the contract. However variance derivatives can be traded throughout the life of the contract and – as variance is linear in time – the derivatives can be valued even after the initial trade. The only difference to a client wanting to trade into a Variance future between contract expiry dates will be the traded price. This is because the price you will be trading at will have a realised variance portion as well as an implied portion as opposed to only an implied value.
In the past, traders wanting to trade volatility have done so by hedging their portfolios with options, which act as an insurance policy against increases or decreases in the market in order to isolate the investor’s exposure to volatility itself. The disadvantage of this approach is that as soon as the market rises or falls, the investor has to buy a new option applicable to the new value to eliminate directional risk. Trading variance is more efficient as it eliminates the need to constantly re-hedge as the market moves about.
