At the beginning of January 2022, the S&P 500 was around 4800, but in mid-May it hit a low of 3900 – a drop of over 20%. The Nasdaq had fared even worse, falling close to 30%. It is one of the worst starts to a year in history with no end in sight.
It is not difficult to find the reasons for the destruction. When inflation runs high the Federal Reserve traditionally moves into an aggressive hiking mode. In May 2022 the Fed Funds rate was increased by 50bp and then another 75bp – the biggest hike for 28 years – at the June meeting. The equity market was also significantly overbought; market pundits have been saying that for over a year. The war in Ukraine and the beginning of quantitative tightening provided even more dry tinder for the bonfire. Equity strategists agree that in the face of a firestorm, investors should give serious thought to hedging. “Hedging is definitely a topic because inflation is going up. Where do you hide if bonds are falling, equities are falling? How do you hedge against higher rates, lower bonds and lower equities?” asked one trader at a London sell-side firm.
As volatility surges, it gives equity investors one of the only opportunities to hedge equity risk and gain exposure to a different type of risk. There are a number of different products in play, such as VIX futures and options, variance (or var) swaps and VIX equity-linked notes (ELNs).
The VIX options market offers an ideal opportunity to hedge volatility, by, for example, buying calls which will increase in value as vol increases. It is a hugely liquid market, and, interestingly, about 40% of VIX options trading is still conducted by open outcry. Not only does it offer an opportunity to hedge equity weakness by buying volatility, the VIX listed market is now so large that it bears a lot of the attributes of an entirely separate asset class.
Variance (var) swaps are less costly to execute and have been around for a lot longer than the VIX listed products market. The first var swaps were traded in the late ‘90s. The basic structure consists of a fixed payment leg and a floating payment leg, as do all swaps. In a var swap, the fixed leg pays an amount based on the implied volatility of the underlying used as the reference in the transaction. The floating leg pays an amount based on the realized volatility of the price changes in the underlying.
- Hedging equity risk
- VIX futures
- Variance swaps
- VIX Analytics and Modelling