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A measure of variation

Category: China, Singapore, Global, U.S.A.

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Volatility forecasting is an important task in financial markets, and it has held the attention of academics and practitioners for decades. Amundi’s Gilbert Keskin and Eric Hermitte give Asia Asset Management a heads up on some of the latest developments in this space.

What are the benefits of investing in volatility? How does volatility fit into an investment portfolio?

An investment in volatility, if properly managed, has several potential benefits in a portfolio, namely: diversification, de-correlation and absolute return. Since a long volatility position is negatively correlated to equity and credit markets, a downturn in either market is generally associated with a rise in volatility. Therefore an investment in volatility can be a unique source of performance in a crisis period, as it would be able to deliver positive returns while traditional assets would have experienced losses.

However, volatility can be very dynamic, and it can move up and down fairly quickly due to its natural tendency to mean revert. Therefore, an actively managed volatility strategy is critical in order to deliver performance when volatility changes (either up or down), and not only when volatility spikes due to crises. As a result, an actively managed, long and short volatility strategy would be able to deliver absolute returns, and not returns that are dependent on the direction of markets.

What impact can an investment in volatility have on returns?

Given the de-correlated nature of this asset class, an investment in volatility can help to smoothe the returns of an equity or balanced portfolio, and reduce volatility and drawdowns over time. Additionally, if volatility is harnessed as an alpha source (and not as a pure hedge) an additional benefit is improving overall returns. Given the lacklustre performance of equities over the last decade and low yields in developed-market bonds, investors are hungry for returns. If volatility can be harnessed to generate returns with an attractive target (i.e. cash + 4% or other absolute return target) it can have a positive impact on expected returns.

How can you effectively forecast volatility at the start of an investment period?

It is very difficult to forecast volatility at the start of an investment period, and even the best proprietary tools are not a perfect predictor of when the next volatility spike will happen. In fact, volatility is based on uncertainty, and tends to rise at moments when the markets least expect it. However, there are some quantitative and macro factors which can give a good indication of whether it will be a high or low volatility environment. On the quant side, the volatility skew is an indicator of the level of risk aversion, as it measures the implied volatility of out-of-the-money puts versus out-of-the-money calls. When the skew is up, this is a sign that investors are willing to pay more for puts versus calls, a sign of risk aversion. The volatility term structure is another indicator of risk aversion. Generally upward-sloping in normal markets, the term structure can become flat or inverted during times of market stress. Finally, macroeconomic factors are just as important – especially in today’s environment – to form a view on volatility. In the next twelve months, volatility is expected to remain moderately high, given the nagging uncertainties in the economic environment. The debt crisis is not resolved, despite three months of respite thanks to LTRO liquidity injections. The structural problems of unemployment and lack of growth remain; the resurgence of rising yields in Spain and Italy are particularly worrying; political factors will also contribute to macro uncertainty (i.e. elections in France, Greece, the US, and the transition of power in China); and finally, geopolitical tensions on commodity prices and inflation can also influence volatility over the next 12 months.

Is some volatility positive and even welcome? How can you capitalise on it?

In today’s market environment, there is unfortunately no way to avoid volatility. If investors find a way to benefit from volatility, this can become a positive source of alpha in a portfolio. Many volatility players seek to benefit from spikes in volatility. While this can certainly be one source of return during crisis periods, another way to capitalize on volatility is by trading its short-term fluctuations. In a “risk-on / risk-off” environment, trading volatility fluctuations can be a good way to benefit from short-term uncertainty. We certainly hope that 2008 was an exception to the rule, and that volatility spikes will be less violent going forward. However, short-term fluctuations will always be the rule in volatility markets, even if volatility remains range-bound for a period of time. Trading short-term fluctuations can therefore be a fruitful way to generate alpha from volatility in all market environments. Amundi is a pioneer and leader in volatility management, having established an investment process to capitalise on volatility since 1999 and an award-winning track record that has proven to work in different market environments across various cycles and crises.

This document is for information only. While reasonable care has been taken to ensure that the information contained herein is not untrue or misleading at the time of publication, Amundi makes no representation as to its accuracy or completeness. Opinions expressed in this report are subject to change without notice, and no part of this document is to be construed as an offer, or solicitation of an offer to buy or sell any securities or financial instruments whether referred therein or otherwise. We do not accept liability whatsoever whether direct or indirect that may arise from the use of information contained in this document. Amundi, its associates, directors, connected parties and/or employees may from time to time have interests and or underwriting commitments in the securities mentioned in this document. Past performance is not necessarily indicative of future result. All investments carry certain elements of risk and accordingly the amount received from such investments may be less than the original invested amount. Information presented herein is as of 19 May 2012.

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