Variance Swaps

volgamma · Post by **volgamma** » Tue Jun 19, 2012 5:16 am

Between 2007 and 2009, there were days when the market was up (down) 3 or 4% five minutes before the close, only to rally (fall) an additional 1-2% in the final few minutes. What role did variance swaps play in this occurrence? If most traders were long the var swaps (and therefore gamma), why did the market jump become more volatile at the close?

FDAXHunter · Post by **FDAXHunter** » Tue Jun 19, 2012 8:18 am

So, for starters, this has nothing to do with variance swaps per se. Any product that takes the end-of-session as a reference price with hedging implications can have this... "feature". It doesn't even need to have convexity (which makes it worse/better)

You say "most traders were long variance swaps". A moment's contemplation will reveal that "most traders" cannot be long. It's a derivative instrument and so for every contract that is bought, another one is sold short. And that's your answer right there: the trader's who were short variance (convexity in general) and who were dynamically hedging, had to frantically get their hedges off at the respective reference price.

This wasn't only variance swaps, by the way, there was a lot of short convexity from structured products that was in the market and that was dynamically hedged (leading to said effects). Banks (French Banks in particular) have a love affair with short convexity.

chiral3 · Post by **chiral3** » Tue Jun 19, 2012 1:56 pm

Also, variance gets sourced: HFs trade the short end, gamma trades, pensions sell straddles at the long end, vega trades, institutions trade quasi costless structures at the far end of the belly. Maybe a dealer will take some calendar risk to make it work but most risk is transferred. Look at last Friday in the US ahead of greek elections: most variance bid up by close while the the market rallied. Yesterday the var curve twisted but fixed strike vols.... Per FDAXs last comment, a French cie inverted the sx5e 3s5s a few weeks ago on a structured note trade. In the US, this past quarter was interesting: there was a great earnings season followed by... nothing, the wait and watch of elections and austerity, fairly wide (per index unit) futures and, by some estimates, massive gamma (spx 1% ca. $25bln). Oh, and it's a triple witching month. Cash trading has always had gap features but much of what we've seen has less to do with this daily behavior and more with the bigger issues.

Strange · Post by **Strange** » Tue Jun 19, 2012 3:38 pm

FDAX is right (as usual). Given that variance is a derivative contract, there are as many longs as there are shorts. However, you could say that the dealer community is long or short variance as a group - unlike clients, dealers delta hedge their variance swaps and would trade massive amounts of delta MOC.

apine · Post by **apine** » Tue Jun 19, 2012 6:12 pm

as already pointed out, open interest has to match. what makes the difference is who is long and who is short. if the longs are dynamic hedgers and the shorts are not, then the open interest will have a dampening effect on the market. the opposite is also true.

FDAX and chiral note that there are structured products that give "investors" (read: non-dynamic hedgers) long convexity positions and thereby give short positions to dynamic hedgers (the dealers). it doesn't matter if the original source of the structure buys variance to hedge its position, the seller of that will most likely be a dynamic hedger. when this becomes large relative to the amount of underlying traded, then things become squirrelly (volatile).

granchio · Post by **granchio** » Tue Jun 19, 2012 10:54 pm

that's all true. but... there is a technicality.

if you are a dealer and dynamically delta hedging, having covered the gamma from varswaps with vanillas, you _have_ to do yourbale delta on the close. the guy that did vanillas against you, if he is a dyn delta hedger, can do his delta whenever he chooses.

this can lead to short term unbalances on the close, that should cancel out longer term

overall, i heartedly agree that the balance between the volume of dyn delta hedgers and not_dyn_delta_hedgers is a bigger factor

teddy · Post by **teddy** » Tue Aug 28, 2012 7:59 pm

agreed - this year, the elephant in the room was the var overriding ETF from CS.

that is, dealers (dyn hedgers) were long var indeed.

however, that behaviour didn't work in the last couple of months , any idea what new flows determined the change?