JUNE 2012

VOLATILITY AS AN ASSET CLASS

Societe Generale Corporate & Investment Banking Global Markets Division | CROSS-ASSET SOLUTIONS GROUP Julien Lascar Cross Asset Solutions

CONTENTS
VOLATILITY:
WHAT IS IT? WHICH VOLATILITY? WHAT TO DO WITH IT?

TAIL HEDGING
HOW TO TRADE VOLATILITY VIX IS THE BEST EQUITY VOLATILITY INDEX ACCESS TO VIX CASE STUDY

ALTERNATIVE INVESTMENT
VOLATILITY PREMIUM ACCESS TO VOLATILITY PREMIUM CASE STUDY

VOLATILITY
WHAT IS IT? WHICH ONE? WHAT TO DO WITH IT?

VOLATILITY
WHAT IS IT?
A MEASURE OF RISK Volatility most frequently refers to the standard deviation of the continuously compounded returns of a financial instrument with a specific time horizon. It is often used to quantify the risk of the instrument over the time period.

WHICH VOLATILITY?
IMPLIED vs. REALIZED VOLATILITY IMPACTED BY TIME PERSPECTIVES (MATURITY), LEVEL OF RISK (STRIKE/SMILE) EACH UNDERLYING HAS ITS OWN VOLATILITY MODELISED DIFFERENTLY Bp/day for HJM model (Interest rate) %/year for Black model (FX, Equity, Commo)

WHAT TO DO WITH IT?

CAPTURE OPPORTUNITIES

VOLATILITY WHAT TO DO WITH IT?

HEDGING: OPPORTUNITIES INVESTMENT: OPPORTUNITIES

TAIL HEDGING

ALTERNATIVE INVESTMENT

TAIL HEDGING
HOW TO TRADE VOLATILITY? VIX IS THE BEST EQUITY VOLATILITY INDEX ACCESS TO VIX CASE STUDY

TAIL HEDGING HOW TO TRADE VOLATILITY?

LISTED/OTC OPTIONS ON AN EQUITY INDEX

Liquidity
VARIANCE/VOLATILITY SWAPS

Exchange of realized volatility at maturity with a pre-determined fixed amount, The Variance Strike. Spot Start, Forward Start.

Roll Mgt

Bid-Offer Spd
VIX FUTURES

The benchmark for stock market volatility, measuring implied short-term volatility of S&P 500 Index options.

Flexibility

Cost of Carry
ETNs & ETFs

SYSTEMATIC FUNDS

Transparency

TAIL HEDGING VIX IS THE BEST PROXY

WHAT IS VIX ?

The benchmark for stock market volatility, measuring implied short-term volatility of S&P 500 Index options. Highly Transparent & Liquid VIX futures are exchanged traded on the CBOE. Tight Bid/Offer Spread especially in comparison to Vol and Variance swaps.

SPX Index 200% 180%

HSI Index

VIX Index 350%

300% 160% 140% 120% 250%

200%

WHY VIX ?

100% 80% 60% 40% 50% 20% 0% 0%

Negative Correlation with Equity Market

150%

When equity market are dropping, they all move down

100%

TAIL HEDGING ACCESS TO VIX BASIC WAY

ROLL VIX FUTURE CONTRACTS
But, the market is in contango most of the time

Future Price

COST OF CARRY

Time

TAIL HEDGING ACCESS TO VIX SMART WAY

SGI VI BETA INDEX Calculated by S&P
The SGI VI Beta Index provides long implied volatility exposure through VIX futures. The Index invests in the VIX futures contracts through a utility function, which aims to provide the best roll in

order to benefit from:

The smallest carry cost1 of the contango term structure (low volatility regime). The highest positive carry earning of the backwardation term structure (high volatile regime).

Positive carry in backwardation markets Negative carry in contango markets

The Index contains a dynamic exposure that leverages expo to VIX Futures when VIX is going in backwardation

The higher the volatility, the higher the exposure to the short-term futures contract.
High Transparency & Liquidity

1Primarily

invests from 1st to 6th contract 1/5th of positions are daily rolled.

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TAIL HEDGING CASE STUDY 1 - DIVERSIFIED PORTFOLIO (KOREA)

The increased allocation of the SGI VI Beta Index to the diversified portfolio shows enhanced

performance.
Diversified Portfolio 90% Diversified Portfolio + 10% SGI VI Beta Index 95% Diversified Portfolio + 5% SGI VI Beta Index SGI VI Beta Index 180 170 160 150 140 130 120 110 100 90 Jun-2007 Jun-2008 Jun-2009 Jun-2010 Jun-2011 100 0 Jun-2012 500 400 700 600

Diversified Portfolio
KIS Govt Bonds 5Y+ (KISKGV5Y Index): Korean Equities (KOSPI2 Index): Commodities (DJUBS Index): 75% 20% 5%

300
200

Annualised Return Comparison Diversified Portfolio Since 18 Jun 2007 (5 Year) Since 1 Sep 2008 (Financial Crisis) Since 14 Mar 2011 (Launch Date)
Source: Bloomberg as of June 18th 2012

6.90% 9.23% 5.54%

95% x Diversified Portfolio + 5% SGI VI Beta 8.80% 11.49% 7.39%

90% x Diversified Portfolio + 10% SGI VI Beta 10.68% 13.72% 9.22%

THE FIGURES RELATING TO PAST PERFORMANCES AND SIMULATED PERFORMANCES REFER TO PAST PERIODS AND ARE NOT A RELIABLE INDICATOR OF FUTURE RESULTS. THIS ALSO APPLIES TO HISTORICAL MARKET DATA

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TAIL HEDGING CASE STUDY 1 - DIVERSIFIED PORTFOLIO (HONG KONG)

The increased allocation of the SGI VI Beta Index to the diversified portfolio shows enhanced

performance.
Diversified Portfolio 90% Diversified Portfolio + 10% SGI VI Beta Index 95% Diversified Portfolio + 5% SGI VI Beta Index SGI VI Beta Index 160 150 140 130 700 600 500 400

Diversified Portfolio
iBoxx ABF Hong Kong TR Index (ABTRHK Index): 75% Hong Kong Equities (HSI Index): 20% Commodities (DJUBS Index): 5%

120
110 100 90 Jun-2007

300
200 100 0 Jun-2012

Jun-2008

Jun-2009

Jun-2010

Jun-2011

Annualised Return Comparison Diversified Portfolio Since 18 Jun 2007 (5 Year) Since 1 Sep 2008 (Financial Crisis) Since 14 Mar 2011 (Launch Date)
Source: Bloomberg as of June 18th 2012

4.18% 2.98% 0.53%

95% x Diversified Portfolio + 5% SGI VI Beta 6.18% 5.42% 4.53%

90% x Diversified Portfolio + 10% SGI VI Beta 8.16% 7.85% 2.53%

THE FIGURES RELATING TO PAST PERFORMANCES AND SIMULATED PERFORMANCES REFER TO PAST PERIODS AND ARE NOT A RELIABLE INDICATOR OF FUTURE RESULTS. THIS ALSO APPLIES TO HISTORICAL MARKET DATA

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ALTERNATIVE INVESTMENT
VOLATILITY PREMIUM ACCESS TO VOLATILITY PREMIUM CASE STUDY

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ALTERNATIVE INVESTMENT VOLATILITY PREMIUM: IMPLIED VS. REALIZED

The observed difference between implied and realized volatility is called the volatility risk

premium
In option markets, price inefficiencies exist due to a structural imbalance between volatility buyers and sellers. Market participants - generally large institutions are mainly hedgers and have to buy at a premium to attract capital into the derivative market.
40% 30% 20% 10% 0%

Average 4.8% / y

-10%
-20% -30% -40% -50% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Average 1-month historical daily volatility risk premium between VIX and S&P 500

Source: Bloomberg, from 02/01/1990 to 15/03/2010 THE FIGURES RELATING TO PAST PERFORMANCES AND SIMULATED PERFORMANCES REFER TO PAST PERIODS AND ARE NOT A RELIABLE INDICATOR OF FUTURE RESULTS.

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ALTERNATIVE INVESTMENT CAPTURE THE VOLATILITY PREMIUM BASIC WAY

BASIC WAY: SHORT VARIANCE SWAP
VARIANCE SWAPS ARE FORWARD CONTRACTS ON THE REALIZED SAMPLE VARIANCE OF RETURNS OF AN UNDERLYING ASSET. THEY PROVIDE A LINEAR PAYOFF THAT IS A FUNCTION OF THE SAMPLE VARIANCE OVER THE CONTRACT LIFE.

LONG LEG: IMPLIED VOLATILITY

SHORT LEG: REALIZED VOLATILITY

Advantages
Can be easily customised

Disadvantages
Higher bid-offers Less liquid, as OTC

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ALTERNATIVE INVESTMENT CAPTURE THE VOLATILITY PREMIUM SMART WAY (1)

SGI VOL PREMIUM DYNAMIC 2 INDEX
1. Trend Indicator
Trend indicator to determine the position on the variance

Trend Indicator
Short

swaps Long or Short?

The Trend Indicator is a dynamic mechanism that looks at
If positive Trend Indicator If negative

different market parameters

short term realized volatility of S&P 500 Index change in VIX the observed volatility premium

Short position in 1M Variance Swaps (40% leverage) Long position in 1M Variance Swaps (10% leverage)

Long

2. Taking a Long/Short Position

Positions taken each day in 1-month variance swaps, on a

fraction of the index value.

The index is computed on a daily basis using mark-to-market

Short position allows to capture the spread between implied and realized volatility on the S&P 500 Index. Long position enables to quickly offset the risk of a short realized volatility exposure in volatile markets.
Buyer pays the swap strike

levels of the variance swaps.

Seller of variance swap

Buyer of variance swap

The figures used in this example are given for purely indicative purposes, the objective is to describe the mechanism of the product. It allows an understanding of how the product would have performed at different market stages over previous years, but is no guarantee as to future returns and has no contractual value

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ALTERNATIVE INVESTMENT CAPTURE THE VOLATILITY PREMIUM SMART WAY (2)

3. Dynamic Exposure
The dynamic exposure mechanism makes it possible to deleverage more quickly in case of a sudden rise of volatility

(40% leverage for a short position and 10% leverage for a long position).
The Index tracks the performance of a variance swap portfolio.

1The 2 3

portfolio is usually made up of around 21 short or long positions, corresponding to the number of business days during the month.

Computed one day before

Number of business days corresponding to 30 calendar days since the launch of the previous variance swap (Trend Indicator is the one observed for the week, not necessarily on that day)

The figures used in this example are given for purely indicative purposes, the objective is to describe the mechanism of the product. It allows an understanding of how the product would have performed at different market stages over previous years, but is no guarantee as to future returns and has no contractual value

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SGI VOL PREMIUM DYNAMIC 2 INDEX

SGI Vol Premium Dynamic 2 Index 350 300 250 200 150 100 50 Jan-1999
1Y 5Y Since Launch (14 Mar, 2011) Volatility (5Y) Sharpe SGI Vol Premium Dynamic 2 0.04% 7.48% 4.02% 9.74% 0.77

S&P500 Index

Source: Bloomberg as of June 18th 2012

Jan-2003

Jan-2007

Jan-2011
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Source: Bloomberg as of June 18th 2012 THE FIGURES RELATING TO PAST PERFORMANCES AND SIMULATED PERFORMANCES REFER TO PAST PERIODS AND ARE NOT A RELIABLE INDICATOR OF FUTURE RESULTS. THIS ALSO APPLIES TO HISTORICAL MARKET DATA

IMPORTANT INFORMATION
The SGI VI Beta Index (The Index) is the sole and exclusive property of Socit Gnrale (SG). SG has contracted with Standard & Poors (S&P) to maintain and calculate the Index. S&P shall have no liability for errors or omissions in calculating the Index. The VIX is the property of the Chicago Board Options Exchange, Incorporated. The VIX Index has been licensed for use by SG in connection with the Index. The SGI Vol Premium Dynamic 2 (The Index) is the sole and exclusive property of Socit Gnrale (SG). SG has contracted with Standard & Poors (S&P) to maintain and calculate the Index. The S&P 500 Total Return index is the exclusive property of S&P and the CBOE Volatility Index (the VIX) is the property of the Chicago Board Options Exchange, Incorporated. The S&P 500 Total Return index and the VIX have been licensed for use by SG in connection with the Index. S&P shall have no liability for any errors or omissions in calculating the Index. Without prejudice to its legal or regulatory obligations, Socit Gnrale may not be held responsible for any financial or other consequences that may arise from investing in a product having as its underlying the index described herein (the Index), and investors are responsible, prior to making any investment in a product having the Index as its underlying, for making their own appraisal and, if they deem it necessary, to seek and obtain professional advice on the risks and merits of the product. No offer to contract / no possibility to invest directly in the Index: this document does not constitute an offer, a solicitation, an advice or a recommendation from Socit Gnrale to purchase or sell the Index, which cannot be invested in directly. The purpose of this document is simply to describe the principles and main financial characteristics of the Index. General selling restrictions: a product having the Index as underlying may be subject to restrictions with regard to certain persons or in certain countries under national regulations applicable to such persons or in said countries. It is each investors responsibility to ascertain that it is authorised to conclude, or invest into, this product. By undertaking such an investment, each investor is deemed to certify to Socit Gnrale that it is duly authorised to do so. Warning regarding the Index: the Index is the sole and exclusive property of Socit Gnrale. Socit Gnrale does not guarantee the accuracy and/or the completeness of the composition, calculation, dissemination and adjustment of the Index, nor of the data included therein. Socit Gnrale shall have no liability for any errors, omissions, interruptions or delays relating to the Index. Socit Gnrale makes no warranty, whether express or implied, relating to (i) the merchantability or fitness for a particular purpose of the Index, and (ii) the results of the use of the Index or any data included therein. Socit Gnrale shall have no liability for any losses, damages, costs or expenses (including loss of profits) arising, directly or indirectly, from the use of the Index or any data included therein. The levels of the Index do not represent a valuation or a price for any product referencing such Index. The Index rules (the Index Rules) define the calculation principles of the Index and the consequences on this Index of extraordinary events which may affect one or several of the underlying programmes on which it is based. A summary of the Index Rules is available either online on the website This index includes embedded leverage which amplifies the variation, upwards or downwards, in the value of the underlying instrument(s). Commercial nature of the document: this document is of a commercial and not of a regulatory nature. Information on market data presented in this document: the market information presented in this document is based on data at a given moment and may change from time to time.

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Confidentiality: this document is confidential and may be neither communicated to any third party (with the exception of external advisors on the condition that they themselves respect this confidentiality undertaking) nor copied in whole or in part, without the prior written consent of Socit Gnrale.
Conflict of interest management: The roles of the different teams involved within Socit Gnrale in the design, maintenance and replication of some of the Indices have been strictly defined. Where Socit Gnrale holds the product and other positions exposing it to some of the Indices for its own account, the replication of these Indices is made in the same manner by a single team within Socit Gnrale, be it for the purpose of hedging the product held by external investors or for the purpose of the positions held by Socit Gnrale acting for its own account. Socit Gnrale may take positions in the market of the financial instruments or of other assets involved in the composition of some of the Indices, including as liquidity provider.

E-mail address: sgindex@sgcib.com Webite: www.sgindex.com Bloomberg Page: SGIX

Socit Gnrale Index

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IMPORTANT INFORMATION
The information contained herein, including any expression of opinion, and any information which accompanies this presentation or which is supplied subsequently, has been obtained from or is based upon sources believed to be reliable but has not been independently verified and is not guaranteed as to accuracy. This presentation and any information which accompanies this presentation does not constitute, and under no circumstances should be considered in whole or in part as, an offer to buy or sell, a solicitation, a price (firm or otherwise), advice or a recommendation of any kind, to acquire or dispose of any transactions and to the extent permitted by law SG is not, and will not be, responsible for ascertaining whether all the risks and other significant factors associated with the transactions contemplated herein have been identified or disclosed, nor for providing advice to you:- (1) as to whether you should enter into the transaction; or (2) on the documentation to be used for the transaction; or (3) on the merits of purchasing or selling any investments mentioned herein. The information contained herein is indicative and you must make your own assessment of the transaction and the risks and benefits associated with it and of all the matters referred to in the preceding sentence and, in this connection, you should consult, to the extent necessary, your own legal, financial, tax, accounting and other professional advisors prior to entering into any transactions. Neither SG nor any of its officers or employees makes any representation as to, or assumes any responsibility or liability for, the merits, suitability, expected or projected success, profitability, performance or benefit of any such transaction. SG recommends that you enter into transactions only after having considered, with the assistance of external advisors, without reliance upon SG, the specific risks of any transaction, including but not limited to, the financial, investment, legal, tax and accounting implications so as to enable you to appraise and understand the financial and legal terms of such transaction and to enter into such transaction in reliance on your own judgment and that of your advisers and not on any views expressed by SG. This presentation was prepared exclusively for your benefit and your internal use. Neither the presentation nor any of its contents may be disclosed to, reproduced or used or relied upon by, any other person or used for any other purpose without the prior written consent of SG. Notice to Australian Investors: Socit Gnrale (ABN 71 092 516 286) is regulated in Australia by APRA and ASIC and holds an AFSL no. 236651 issued under the Corporations Act 2001 (Cth) ("Act"). The information contained in this document is only directed to recipients who are wholesale clients as defined under the Act. SG Securities (HK) Limited is a Registered Foreign Company and Foreign Financial Services Provider in Australia (ARBN 126058688), and is exempt from the requirement to hold an Australian financial services license under the Act in respect of financial services. SG Securities (HK) Limited is regulated by the Securities & Futures Commission under Hong Kong laws, which differ from Australian laws. The information contained in this document is only directed to recipients who are wholesale clients as defined under the Act. Notice to Hong Kong Investors: This document is distributed in Hong Kong by SG Securities (HK) Limited and Socit Gnrale Hong Kong Branch, which is regulated by the Securities and Futures Commission and Hong Kong Monetary Authority respectively. This document is issued solely to "professional investors" within the meaning of the Securities and Futures Ordinance (Cap. 571) of Hong Kong and any rules made under that Ordinance. Notice to Japanese Investors: This document is distributed in Japan by Socit Gnrale Securities (North Pacific) Ltd., Tokyo Branch, which is regulated by the Financial Services Agency of Japan. This document is intended only for the Specified Investors as defined by the Financial Instruments and Exchange Law in Japan and only for those people to whom it is sent directly by Socit Gnrale Securities (North Pacific) Ltd., Tokyo Branch, and under no circumstances should it be forwarded to any third party. Notice to Singapore Investors: This document is provided in Singapore by or through Socit Gnrale, Singapore Branch and is only provided to institutional investors, as defined in Section 4A of the Securities and Futures Act, Cap. 289. Notice to Investors in Asia-Pacific region: This document is to present you with all our capital markets activities across Asia- Pacific region and may only be distributed to the professional institutional investors. The product mentioned in this document may not be eligible or available for sale in your country and may not be suitable for all types of investors.

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E-mail address: sgindex@sgcib.com Webite: www.sgindex.com Bloomberg Page: SGIX

Socit Gnrale Index

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