Triple3 brings volatility trading to bonds

11-Sep-2014

By Wouter Klijn

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Sydney-based research and investment firm Triple3 has developed an index that will track the volatility of fixed income securities.

The launch of the index, YLDVOL, will allow institutional investors to trade volatility as if it was an asset class, much in the same way investors can trade the volatility of equities through the VIX index and its associated derivatives.

It has huge potential in the over-the-counter market, where 80 per cent of outstanding derivatives are interest rate derivatives, representing a total outstanding value of US$561 trillion.

“This has tremendous implication for asset management, because fixed income people can now use volatility in the same way that equity people do,” Triple3 executive director Simon Ho told theinstoreport.

“So YLDVOL derivatives, such as futures and options, will open a whole new dimension for interest rate trading and hedging.

“I’ve spoken to banks, fixed income managers and hedge funds who trade VIX – they want to be able to trade equity versus fixed interest rates and do relative value there.

“Then of course you’ve got the exchange-traded funds issuers.

“There are 28 exchange-traded products (ETP) based on the VIX, so you can imagine they are all lining up to do this and replicate the same success they saw in the VIX ETPs.

“It is a whole gamut of people who are interested in using this product.”

The new index also has a very practical application for banks with large mortgage books.

“When you have options on those futures, you expose people to something that is called the volatility of volatility,” Ho said.

“You might think ‘oh, how esoteric’, but actually a lot of mortgage books have exposure to the vol of vol, it is something called the pre-payment risk.

“When interest rates go down, people reorganise their loans and get lower rates and in other words the loan is pre-paid; it is paid faster than they expect and it changes the duration of the bond.

“Right now there is no real, simple way to hedge that. With the advent of these, there will be.”

The YLDVOL index represents the constant maturity 30-day implied volatility of the CME 10-year Treasury note contract, expressed in annualised basis points terms.

Its construction is designed to approximate a volatility swap, making it different from the VIX method, which relies on variance swaps.

It was designed after extensive consultation with industry practitioners to ensure it accurately reflected the conventions of the interest rate market, Ho said.

“Our business is dedicated to anything that has to do with volatility and so we set out to build a better index,” he said.

“Currently, the VIX methodology is subject to jumps every so often, purely because of its design.

“It is a malfunction within its construction. It has nothing to do and is no reflection of the actual market volatility.

“It has to do with technical issues around contract rollovers and when it does that usually produces a jump down for no good reason.

“It introduces intervariability, noise, into the index which is not necessary.”

Recently, the Chicago Board Options Exchange (CBOE), which owns the intellectual property of the VIX index, announced it would launch a volatility index for fixed income assets in November, but Ho said that index had the same methodology as the equity volatility index, including all its flaws.

“It happens that the CBOE announced … that they are going to do one as well, which is a competitor. That is annoying, but that is life,” he said.

“Our index is better and I know that because we have spoken to a wide audience of interest rate participants and they have been heavily involved in influencing the design.

“We want to commercialise it in the over-the-counter space as well as in the listed space, so we are talking to an exchange about that.”

He could not reveal the exchanges involved, but said he was in conversation with a European and a United States exchange.

“We would be the index sponsor and they would then develop futures and options off of the index,” he said.

“Hopefully, we will be first to have something tradeable in the over-the-counter space.”

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