Equity Derivatives Insights

Occasionally, central banks will reach out to market practitioners to gain perspective on significant developments that may warrant their attention. Last week, we had a brief meeting with one such institution, and I thought it would be helpful to share some of the insights we discussed. I highlighted three key observations from the U.S. derivatives market: 1) Structural Disruptions in the VIX Complex In both August of last year and again this past April, we observed several irregularities in the VIX complex. Most notably, we saw two of the strongest spot-vol beta dynamics ever recorded, along with one of the widest spreads between spot VIX and front-month VIX futures. However, what stood out the most was the severe deterioration in liquidity during moments of stress. Both the electronic and IBD markets were quoting spreads of 20–40 vols wide on thicker delta strikes that typically trade within 2–5 vols. Execution in the VIX options market became extremely difficult—not just for retail participants, but for professionals as well. While wider spreads during volatility spikes are not unusual, the dislocations seen in those two months exceeded what we witnessed in March 2020, February 2018, and August 2015. For anyone active in VIX derivatives, it’s important to acknowledge that the liquidity profile when volatility spikes in this market is changing. 2) The Volatility Market Has Become More Tactical Historically, periods of extreme positioning—either heavily short or long volatility—would take time to unwind. Today, however, we are seeing episodes of extremely high notional short Vega and long Vega, but the unwinding process is more orderly and occurs far more quickly. Those profiles can toggle up and toggle down within hours, whereas historically it took weeks. Dealers have developed more flexible tools for managing inventory, primarily thanks to the expanded strike and tenor selection available through exchanges. Hedging client risk is now cleaner and more efficient. Additionally, the end-user community has become far more sophisticated in its use of derivatives. What might have once been a “set it and forget it” position a decade ago can now be adjusted dynamically based on market conditions. 3) The Rise of QIS: A Growing Force in Derivatives The quantitative investment strategies (QIS) market is rapidly expanding and is beginning to outsize even some of the largest volatility specialist hedge funds. U.S.-based QIS derivative programs now manage hundreds of billions in AUM, and that number continues to grow. Tier-1 banks have streamlined their ability to package, market, and distribute these strategies at scale. The strategies range from yield-focused to hedging-oriented, but the bulk of the assets remain concentrated in short-dated yield enhancement products.

☠️ 𝗘𝗤𝗨𝗜𝗧𝗬 𝗘𝗫𝗢𝗧𝗜𝗖 𝗥𝗜𝗦𝗞𝗦 𝗦𝗘𝗥𝗜𝗘𝗦: 𝗖𝗢𝗩𝗔𝗥𝗜𝗔𝗡𝗖𝗘 ☠️ 👨🔬 The life of an exotic trader often involves selling cheap calls and buying expensive puts. A strategy to make the put more expensive and the call cheaper is to write options not on a single equity, nor on a basket of equities, but on the worst-performing of, say, three equities. 🙃 The human mind struggles to properly conceptualize the distribution of the worst of three assets. While we can easily imagine the worst-case scenario for an individual stock, envisioning what a 'bad scenario' looks like for the worst-performing among multiple stocks is far trickier. That participates in making the worst of a popular solution amongst investors. ⚡ As a result, exotic traders are effectively short worst-of forwards, which means they are not merely short correlation—they are 𝘀𝗵𝗼𝗿𝘁 𝗰𝗼𝘃𝗮𝗿𝗶𝗮𝗻𝗰𝗲. This distinction is 𝗰𝗿𝘂𝗰𝗶𝗮𝗹. Being short correlation carries well if sold at a premium versus realised, and at the end of the day the realised correlation cannot go over 100%! However, being short covariance is different; when it goes wrong, the potential losses are not capped. 😵 Anyone who has traded an exotic book knows the difference 𝘃𝗶𝘀𝗰𝗲𝗿𝗮𝗹𝗹𝘆. Those who navigated the 2008 financial crisis can vividly recall the steep cost of being short covariance. The covariance between equities reached exceptional levels (see graph with SPX-SX5E covariance). At the time, Deutsche Bank, then a major player in equity derivatives, reported losses of €1.7 billion in its exotic books, largely driven by exposure to short covariance risk. Société Générale faced a €500 million loss in Q4 alone due to similar positions. BNP Paribas, another key dealer, posted nearly €2 billion in losses in its equity derivatives business that year, highlighting the potential devastating impact of a short covariance position. ☠️ 𝕭𝖑𝖔𝖔𝖉𝖇𝖆𝖙𝖍 𝖋𝖔𝖗 𝖊𝖝𝖔𝖙𝖎𝖈 𝖙𝖗𝖆𝖉𝖊𝖗𝖘. #structuredproducts #correlation #covariance

*** Different Types of Equity Swaps *** Equity swaps are popular derivatives instruments among institutional investors specially Hedge Funds. Equity swaps are financial derivatives that involve exchanging the returns (including dividends and capital gains) of an equity or equity index for either a fixed or floating rate of return. There are various types of equity swaps, that helps meet different financial needs and strategies of institutional investors. Here are some of the main types: 1. Total Return Swap (TRS) A Total Return Swap allows one party to receive the total return of an equity asset (including dividends and capital gains) while paying a fixed or floating interest rate. The counterparty receives the fixed or floating rate in exchange for paying the total return on the equity. 2. Price Return Swap In a Price Return Swap, one party pays the return based on the price movements of an equity or equity index, excluding dividends, in exchange for a fixed or floating rate. 3. Equity Dividend Swap An Equity Dividend Swap is a financial derivative where one party pays the other the dividends received from a specified stock or basket of stocks over a certain period, in exchange for a predetermined fixed or floating payment. 4. Equity Variance Swap An Equity Variance Swap is a derivative that allows investors to trade future realized volatility against current implied volatility of an underlying equity index or stock. 5. Equity Structured Options Equity Structured Options are customized options designed to meet specific investment strategies, often combining different option features like barriers, knock-ins/outs, and various payoff profiles. 6. Equity Variance Option An Equity Variance Option is an option on the variance (volatility squared) of a stock or index. It allows investors to take a position on the future variance of an underlying asset. 7. Equity Correlation Swap An Equity Correlation Swap is a financial derivative that allows investors to trade the correlation between different stocks or indices within a portfolio. These instruments are sophisticated financial derivatives used primarily by institutional investors to manage risk, hedge positions, or speculate on market movements.

📈 Equity Swaps – My Experience Behind the Numbers When I first worked on equity swaps, I was surprised how powerful they were for hedge funds. Imagine being able to get exposure to the performance of a stock or an index without ever holding the shares directly – that’s what an equity swap does. Here’s how it works in simple terms: One party receives the return on a stock or index (dividends + price movement). The other party receives a financing leg (like LIBOR/SOFR + spread). From an accounting side, this sounds simple, but the reality is where the real learning comes in: Tracking dividend adjustments accurately, Reconciling MTM movements every day, Monitoring reset dates and financing accruals, Ensuring both parties agree on the notional and cash flows. I still remember one of my early reconciliations where a dividend adjustment wasn’t posted correctly. It looked small, but when rolled forward, it created a big difference. That moment taught me – in swaps, tiny details matter more than the big picture. For me, equity swaps are not just contracts – they represent how markets create flexibility, and how our role in operations ensures this flexibility is backed by precision, accuracy, and discipline. #EquitySwaps #FundAccounting #Derivatives #HedgeFunds #NAV #MyExperience #CapitalMarkets #Swaps #EquitySwaps #Finance #TRS