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Panel Discussed "New Developments in Exchange-listed Derivatives—Volatility, Credit, Portfolio Margining, and ETNs" on June 14 at CBOE



The theme "New Developments in Exchange-listed Derivatives: Volatility, Credit, Portfolio Margining, and ETNs," was presented at a 90-minute four-person panel discussion at the Chicago Board Options Exchange (CBOE) on June 14th, 2007.

Mr. William Brodsky, Chairman and CEO of CBOE, welcomed the four panelists and 95 people in attendance, and noted that the topics to be discussed were of interest to many investors. Here are some highlights of the topics covered by the four panelists:

(1) CREDIT DERIVATIVES. Dr. Izzy Nelken, President of Super Computer Consulting in Northbrook, Illinois, noted that:

a) The current notional value for O-T-C credit derivatives is estimated to be about $27 trillion,

b) "Credit default swaps (CDS)" are misnamed because they are more like a digital or binary option rather than a swap - the buyer pays a small amount and the seller potentially might be obligated to pay a huge amount,

c) Some difficulties with the existing O-T-C credit default swaps (CDS) market include the fact that prices are opaque (only selected prices can be observed via specialized services, (e.g. a partial list might include: Markit, Reuters, Bloomberg, Advantage Data); the CDS market is highly concentrated; CDS are based on the recovery rates (and when Delphi defaulted, there was a period when bond prices went up as protection buyers had to buy the bond to deliver); there is a complex ISDA settlement arrangement, purchasers of credit protection are worried about the correlation between the seller and the reference credit; and dealers are most concerned about the Japan-on-Japan risk, especially when both belong to the same keiretsu,

d) An exchange-traded Credit Event Binary Option (CEBO) proposed by CBOE is a binary option that provides protection against defaults on debt securities guaranteed by corporations, with a binary payoff of either $100,000 (when a credit event occurs) or $0, and

e) Potential advantages of the exchange-traded CEBO include:

(i) Prices will become more transparent and viewable by all investors,

(ii) The market will become more widely distributed,

(iii) Not dependent upon recovery rates;

(iv) Settlement will be automatic, determined by CBOE

(v) Default correlation: not a factor in single name

(vi) CEBOs are guaranteed by the Options Clearing Corporation

(2) PORTFOLIO MARGINING. Mr. Douglas J. Engmann, Senior EVP and Managing Director of Equities, FIMAT USA, in San Francisco gave an overview of the new portfolio margining rules. To create more competitive listed securities markets, in July 2005 the the SEC approved a "portfolio margining" pilot program to effectively lower margin requirements, beginning with broad-based index options and ETFs. By July 2006, the SEC expanded the pilot to include individual equity options (excluding the underlying) and single stock futures. Fimat was the only U.S. broker that operated under the two pilot programs. A full portfolio margining program was approved effective in April 2007, with an expansion of products to include stocks, OTC derivatives, ETFs, options on narrow-based indices, and single stock futures (but no CFTC-regulated index futures). Mr. Engmann provided a couple of examples of strategies (married put and long straddle) with offsetting limited-risk positions in which there could be a substantial decrease in exchange required margins when one compares Reg T margins to the new portfolio (or risk-based) margins, and he noted that CBOE now has a new paper featuring a table with margin comparisons for dozens of strategies. Eligibility Guidelines for portfolio margining include the fact that the investor must qualify under the broker's rules on options trading experience and knowledge to trade uncovered calls & puts, and must meet the minimum equity requirements set by the broker (Fimat USA has established $500,000 minimum for a fund; $150,000 for an individual), and must sign a portfolio margin risk disclosure.



(3) EXCHANGE-TRADED NOTES. Mr. Philippe El-Asmar, Managing Director at Barclays Capital in New York, discussed the recent growth of exchange-traded notes (ETNs), and noted that there now are ETNs on commodity indexes, currencies, emerging markets, and the CBOE S&P 500 BuyWrite Index. The eight iPath ETNs are senior, unsecured, unsubordinated debt securities issued by Barclays Bank. They are designed to provide investors with a new way to access the returns of market benchmarks or strategies. ETNs are not equities or index funds, but they do share several characteristics. For example, like equities, they trade on an exchange and can be shorted. Like an index fund, they are linked to the return of a benchmark index. iPath ETNs provide investors with convenient access to the returns of market benchmarks, minus investor fees, with easy transferability and an exchange listing. The ETN structure allows investors to achieve cost-effective, tax-efficient investment in previously expensive or difficult-to-reach market sectors or strategies. iPath ETNs are designed to provide investors a return that is linked to the performance of a market index, minus investor fees. The iPath ETNs currently available are listed on major exchanges and are available for purchase, similar to other publicly traded securities.

Investors can liquidate iPath ETNs one of three ways:

a) Sell in the secondary market during trading hours.
b) Redeem a large block of securities, typically 50,000 securities, on a weekly basis directly to the issuer, Barclays Bank PLC, subject to the procedures described in the relevant prospectus. A redemption charge may apply.
c) Hold until maturity and receive a cash payment from the issuer, Barclays Bank PLC, equal to the principal amount of the units times the index factor on the final valuation date, less the investor fee on the final valuation date.



(4) VOLATILITY AND THE VIX. Mr. Ben Londergan, Co-CEO of Group One Trading in Chicago, discussed use of volatility products and the fact that his firm is the designated primary market maker for options on the CBOE Volatility Index (VIX), a product that was launched in 2006 and has been one of the most successful new index options products of the decade. In May 2007, VIX options had an average daily volume of 71,354 contracts, and open interest was 912,729 VIX call options and 472,926 put options.

Mr. Londergan noted that there are several reasons why investors trade volatility, including:

a) Negative correlation to most equity indexes,

b) Positive correlation to credit prices,

c) Efficient way to manage unwanted market risk,

d) Unique properties of volatility create trading opportunities—

i) Historical difference between realized and implied volatility,

ii) Volatility Term Structure,

iii) High Volatility of Volatility (the historic volatilities in 2006 were 94% for the VIX spot index, 36% for VIX near-term futures, and 10% for the S&P 500 (SPX)).

Key points about the volatility markets include:

a) $80 - $100 million in vega is traded globally each day.

b) SPX-based volatility market is the largest; also good size for volatility based on the EuroStoxx 50 and Nikkei 225 indexes.

c) Vanilla variance swaps are most common, but there is growing interest in variance options, conditional variance, corridor variance, correlation & dispersion and VIX, and growing demand for long-dated options (>10 yrs.)

d) Expiry ranges from 1 month to 10 years. Most activity is 3 months to 1 year.

e) Hedge funds, mutual funds, pension funds, insurance companies are hedging equity volatility risk. End-user groups are slowly broadening, still learning & need to identify risks and benefits. Volatility buyers might become sellers if risk/return is right.

f) Lower Volatility. The implied and realized volatilities of US stock market indexes have dropped in the past five years (the average daily closing price of VIX was 27.3 in 2002 and 12.8 in 2005 - 2007).

g) Negative Correlation. VIX prices generally have had a negative correlation to S&P 500 prices, and the VIX can explode on the upside if S&P prices suffer a big drop. For example, on Feb. 27, 2007, the S&P 500 dropped 3.5%, the VIX spot index rose 64%, and the VIX (near-term) March '07 futures rose 29.5%.

Mr. Londergan also discussed the bid-ask spread and liquidity for the VIX options.

This was the 42nd meeting of Chicago QWAFAFEW (Quantitative Work Alliance for Applied Finance, Education & Wisdom) www.qwafafew.org, and the meeting was jointly sponsored by Chicago PRMIA (Professional Risk Managers' International Association) www.prmia.org


CBOE Volatility Index (VIX)