This Tuesday I’ve got the pleasure of moderating a panel discussion at the CBOE Risk Management Conference on the subject of option usage among institutional investors. Over the last few days I’ve been thinking about how to approach this topic with the panellists, who represent some of the largest and most sophisticated institutional investors across Europe : Aviva Investors (UK), Ilmarinen (Finland), Swiss Life (Switzerland) and PGGM (the Netherlands).
I figure there are broadly 4 ways in which large institutions make use of options :
1. As “Directed Trades” at an institution level, perhaps a macro-level hedge against falls in equity levels or interest rates, these might be against standard indices or volatility controlled indices.
2. At an individual mandate level, in a strategy where options are inherent to the nature of the strategy, for example a strategy that attempts to monetize the premium between implied and realized volatility, a call-overwriting strategy or a tail hedge protection-buying strategy.
3. At an individual mandate level, as one “axe” to represent macro views. Here the advantage of options include the convexity they introduce into the payoff of the trade, and alsothe ability to strictly limit the downside of a trade (ie in terms of premium spent).
4. As a risk management tool, here the downside convexity and the ability to gain long volatility exposure can be particularly powerful, which gives the ability to use options as an risk overlay on much larger investment programs.
Some of the questions and themes that I’m interested in pursuing with our panel include :
What sort of asset classes do institutions tend to use options in?
My feeling is most institutions will gravitate toward using options in the large-cap developed market equity space, as this is where liquidity is most abundant and pricing the most transparent. The extent to which liquidity in Emerging Markets, individual sector indices or single stock indices will be interesting to explore.
My feeling is that the second-most liquid area will be in the main developed-market rates markets. Options on commodities are also traded and it will be interesting to see whether out panellists make use of these.
Is the institutional preference to be net long, short, or neutral gamma and vega?
While it can be shown that in most markets there is a risk premium associated with systematically selling options (ie, going short gamma and vega) this presents a negatively skewed payoff profile (ie, one where occasionally large losses occur). Given that institutions will generally have substantial other exposure in their portfolios including long equity exposures, this creates a tension between the desire to harvest the short-vol risk premia and the desire to provide a tail hedge for the wider institutional portfolio.
Are there challenges in explaining and justifying option-based strategies to the ultimate stakeholders or regulators of the institution?
Options can be powerful tools, but they are also complex and present non-linear risks, not everyone in the field of finance is an options specialist. It will be interesting to see how the institutions our panellists represent have dealt with the challenge of justifying an explaining the strategies employed to the investment committees, boards, shareholders or regulators that they ultimately report to.
How have risk management techniques had to evolve to accommodate growth in options based strategies?
Given that risks in option strategies are non-linear, risk management needs to extend beyond that which would be used for more vanilla long/short trades. Risks include the level or slope of the vol surface increasing or decreasing, the effect of time decay on the P&L of the position and the quadratic “acceleration” of a position’s P&L (positive or negative). Taking account of these risks requires sophisticated techniques and systems, and the challenge is to keep the risks within allowed bounds without negatively impinging on the abilities of those executing the strategy. It will be interesting to hear from the panellists how their internal risk management groups have evolved.
What is the role of the VIX?
Undoubtedly the VIX has become a global benchmark for volatility, but do options specialists make use of the VIX and if so what strategies do they employ? How has the increased volume in the VIX seen over the last 3 years affected these strategies?
What other assets or products are people looking at?
Given the large size of the institutions represented on out panel any strategy must meet liquidity and capacity criteria to be worthwhile, that said there are often opportunities in newer and less traded markets. It will be interesting to hear from our panellists where they are directing their research into new strategies and which areas they feel liquidity needs to improve before they can be used by investors of their scale.
This looks set to be a very varied and interesting session. Check back here for updates or tweet me #CBOERMC with further suggestions for questions or themes.