the basics of Implied Volatility About VSTOXX and VIX Short- and Mid-Term Futures Indices Volatility is a complex investment tool and is aimed at sophisticated investors who understand the way volatility works as an investment and the risk involved in so doing. You should not invest in any volatility related instrument unless you understand the risks involved in such investments (taking independent professional advice as you deem appropriate), and you are capable of assuming such risks. Please see important disclaimers at the end of this document. This material is to be read in conjunction with the relevant base prospectus and relevant final terms referred to in the disclaimers.
Broschürentitel The Basics of Implied Volatility This document provides a basic introduction to the concept of volatility and some of its implications for an investor. The document focuses particularly on the implications for equity markets and outlines the basics of the benchmark equity market volatility indices. However, the document is an introduction and does not attempt to detail all the applications and risks of volatility. OPINIONS SUBJECT TO CHANGE All opinions and estimates are given as of the date hereof and are subject to change. Barclays is not obligated to inform you of any change to such opinions or estimates. Barclays will not be liable for any use you make of any opinion or estimate provided. * The investor fee is the Annual Fee times the applicable closing indicative value times the applicable daily index factor, calculated on a daily basis in the following manner: The investor fee on the inception date will equal zero. On each subsequent calendar day until maturity or early redemption, the investor fee will be equal to the Annual Fee times the closing indicative value on the immediately preceding calendar day times the daily index factor on that day (or, if such day is not an index business day, one) divided by 365. 2
What is Volatility? The diagram below shows the hypothetical price movement of two assets over a period of time. Note that both assets have had the same return ending the period at a price of 1.25. However, the paths taken to get to this point are significantly different. Asset 1 has had significant positive and negative swings in its growth over the term, whilst Asset 2 has had a stable growth over the term. Figure 1 Hypothetical Price Movement 1.50 1.25 1 In addition, volatility for a given asset is unlikely to remain constant. For example, during periods of economic uncertainty equities tend to be more volatile as new information helps investors to significantly re-assess future growth prospects (either positively or negatively). Similarly, during periods of stability equities tend to be less volatile as new information tends to lead to minor adjustments of future growth prospects. What are the types of volatility? There are two types of volatility which may be considered for any asset. The first is a backward looking measure of how volatile the returns of the asset have been historically. This volatility is known as realised volatility and can be calculated using the formula for the standard deviation of returns. 0.75 0.50 Time The measure of the stability (or more accurately instability) of growth in financial assets is known as volatility. Assets such as emerging market equities, which can be subject to significant swings in growth, are said to have a high volatility. Assets such as short dated, low credit risk government bonds, which traditionally tend to have smaller swings in growth, are said to have a low volatility. Note that volatility is not a measure of directional performance (consider the example above), but it is often used as a measure of financial risk. Thus typically assets which exhibit high volatility are considered to be more risky than assets with a lower volatility. The second type of volatility is forward looking, and is a measure of what the market expects the realised volatility to be in the future. As this expected volatility is defined by market participants expectation of how the asset will behave in the future, it cannot be calculated using a formula. Fortunately, there is a reasonable proxy measure that can be derived from market parameters and this is known as implied volatility. 3
The Basics of Implied Volatility How is implied volatility derived? There are a set of traded financial instruments called option contracts, e.g. put options and call options, whose value has been shown to be a function of expected volatility. Furthermore, whilst there is no perfect valuation model for these contracts, there is a generally accepted one. Using this model it is possible to reverse engineer the expected volatility assumption that would be required such that the model would show a value of the prevailing market price. This expected volatility assumption is known as implied volatility. For further information, please take independent professional advice as you deem appropriate. Usual application of the model Reversed engineered application of the model Volatility Other known variables Implied Volatility Other known variables a+b+c+d= d+c+b+a= Properties of Implied Volatility Theoretical Value Market Price Implied volatility is a measure of market sentiment as it is a measure of instability of future returns, and is sometimes referred to as the fear gauge. However, this market sentiment is based on existing imperfect knowledge and assumptions about future growth. As a consequence, it can be very sensitive to news and information flows which may affect the future returns in a market. For example: An earnings report which is worse than expected is likely to have a negative effect on the value of the equity markets. However, the news may also increase uncertainty in respect of potential future earnings. This uncertainty often translates into an increase in implied volatility. An earnings report in line with or better than expectation is likely to have a positive and stabilising effect on the value of equity markets. This stability may translate into a decrease in implied volatility. Furthermore, implied volatility tends to change more sharply than the underlying equity markets. In particular, during periods when equity markets fall significantly, implied volatility tends to increase sharply, often by much more than the percentage fall in the equity market. These properties mean than implied volatility can have a strong negative correlation with equity markets, particularly during periods of negative returns, see Figure 2. Figure 2 Index Performance 6,000 5,000 4,000 3,000 2,000 1,000 These figures refer to past performance. Past performance is not a reliable indicator of future results. Source: Bloomberg, Barclays Capital. 3 rd Jan 2000 31 st Oct 2011 Implied volatility (represented here by the VSTOXX Index) has tended to decline or remain stable in periods of equity market growth. However, it tends to spike in times of market distress. What are the benchmark volatility measures? There are currently two popular measures of implied volatility in equity markets: VIX: which is a measure of the implied volatility of the S&P 500, the US equity market benchmark index. VSTOXX: which is a measure of the implied volatility of the Euro stoxx 50, the European equity market benchmark index. 0 JAN 00 JAN 01 JAN 02 JAN 03 JAN 04 JAN 05 Euro STOXX 50 Index (LHS) JAN 06 JAN 07 JAN 08 JAN 09 JAN 10 JAN 11 VSTOXX (RHS) These measures of implied volatility are calculations, but cannot be traded directly. However, listed futures contracts do exist that allow professional investors to trade on this basis. 90 80 70 60 50 40 30 20 10 0 4
Listed Futures Contract A futures contract is a standardised contract which amounts to an agreement to buy or sell a specified asset of standardised quantity and quality at a specified future date at a price agreed today (the futures price). For example: If an investor were to agree to buy one futures contract entitling them to 100 shares of XYZ plc with an expiration date in December 2011 paying 350, then following the contracts expiration, they would be obliged to accept delivery of 100 XYZ plc shares and pay 350. If an investor were to agree to sell one futures contract worth 100 shares of XYZ plc with an expiration date in December 2011 at 350, following the contracts expiration, they would be obliged to deliver 100 XYZ plc shares to the buyer of the contract and receive 350. What are the volatility indices? An investor who would like to maintain a continuous exposure to implied volatility could face some practical issues. If an investor wishes to maintain exposure to a futures position past the expiry date of the futures contract they currently hold, they must sell it prior to its expiry date and purchase a futures contract with a delivery date further in the future (often the next succeeding futures contract). This is known as rolling from one future to another. In both cases the index sponsors offer two types of indices, namely a short term futures index and a mid-term futures index. The details of how the indices are calculated by the index sponsors are beyond the scope of this note (For details on how these indices are calculated please contact the index calculators, either Standard and Poor s or STOXX Ltd., directly). However, the basic methodology used is summarised on the following page. Fortunately, a number of index providers now calculate volatility indices using futures contracts on the basis of rolling from one future to another as described above. The most popular are: Standard & Poor s VIX family of indices linked to the VIX STOXX Ltd. s VSTOXX family of indices linked to the VSTOXX 5
The Basics of Implied Volatility Short-term futures index: The short-term futures index follows a strategy of systematically rolling futures each day to maintain an average 1-month position, see Figure 3. At the end of each month, the index has 100% exposure to the following month s futures contract (known as the front month contract). Each subsequent day, a proportion of the front month contract is sold and the second month contract is bought. Figure 3 This daily rolling continues such that by the end of the month, the index no longer has any exposure to that front month contract and is fully exposed to the second month contract (which subsequently becomes the new front month contract when the existing front month contract expires). Short-Term Futures rolling mechanism 100% invested in the March future 100% invested in the April future 100% invested in the May future 100% invested in the June future April future May future June future March future April future May future June future FEB mar APR may Source: Barclays Capital Mid-term futures index: The mid-term futures index follows a strategy of systematically rolling futures each day to maintain an average 5-month position, see Figure 4. At the end of each month, the index has equal exposure to the 4 th, 5 th and 6 th month futures contracts. Each subsequent day, a proportion of the index s exposure to the 4 th month contract is sold and the 7 th month contract is bought. Figure 4 This daily rolling continues such that by the end of the month, the index is fully exposed in equal proportions to 5 th and 6 th and 7 th month futures contracts (which, once the existing 4 th month futures contract expires, now become the new 4 th, 5 th and 6 th month futures contracts respectively). Mid-Term Futures rolling mechanism Over each roll period, allocation is systematically shifted from the 4 th month contract to the 7 th month contract June september July october August november octobe August September October November July August September October FEB mar APR may Source: Barclays Capital 6
Another aspect of these indices is that they are often quoted as excess return or total return indices. An index that tracks the return generated by rolling the future contract is known as an excess return index. However, excess return indices do not take into account that an investor having futures exposure would usually be holding the notional amount in cash. Total return indices look to adjust for this by calculating the value of the index as the excess return plus an interest amount. Most index tracking investments relate to the total return indices as these are the best index proxies to a fully committed cash investment with continuous exposure to implied volatility. Implied Volatility VIX Total Return Index VIX Short-Term Total Return Index VIX Mid-Term Total Return Index VSTOXX Total Return Index VSTOXX Short-Term Total Return Index VSTOXX Mid-Term Total Return Index Bloomberg Ticker VIX Index SPVXSTR Index SPVXMTR Index V2X Index VST1MT Index VMT5MT Index Do the volatility indices have a roll yield similar to that of the commodity indices? The VIX and VSTOXX family of indices do rely on the rolling of futures contracts, and therefore do have the potential to experience a roll yield. Like the commodity indices, the roll yield can be either positive or negative. What is a roll yield? 1 Usually the price of the applicable futures contract will not be the same as the current prevailing level of either the VIX or VSTOXX index, (known as the spot price ). However, over time, as the term to expiry of the futures contract shortens, the price of any given futures contract will converge towards the spot price. Thus an investor, rolling a future, i.e. buying a future, holding it for some time and then selling it to buy a longer dated future, will experience either a profit or a loss even if the spot price has remained unchanged. The return generated by the rolling of the future is known as the roll yield. The roll yield can be negative or positive: Negative Roll Yield If the spot price is lower than the futures contract price, then all else being equal, the futures price will decrease over time towards the spot price. In this scenario, the roll yield will be negative, and an index, or an investor, will experience a negative return. Positive Roll Yield If the spot price is higher than the futures contract price, then all else being equal, the futures price will increase over time towards the spot price. In this scenario, the roll yield will be positive, and an index, or an investor, will experience a positive return. 1 Please see the document The Basics of Commodities for more information on the roll yield, available on the ipath website www.ipathetn.eu However, unlike commodity indices, the rolling does not arise from a single roll of the futures contract close to its expiration date. Rather the roll yield arises in smaller amounts each day as the proportion of the shorter dated futures contract (e.g. the March futures contract) is rolled into the longer dated futures contract (e.g. the April futures contract). Over time the roll yield can lead to significant divergence, either positive or negative, between the return of the indices and the spot price of implied volatility. The spot price of a particular underlying is the current prevailing market price of that underlying being quoted for immediate (spot) settlement. 7
The Basics of Implied Volatility Why invest in implied volatility? The properties of implied volatility outlined above highlight the tendency of implied volatility to: increase in times of uncertainty usually associated with declining equity markets and decrease in times of certainty usually associated with stable or increasing equity markets, i.e. implied volatility tends to be negatively correlated to equity market growth, and change more sharply than the underlying equity markets, particularly during sharp falls in the equity market. As a result investors could use an implied volatility investment to: Take a directional view on uncertainty: Diversify the portfolio Investors may have an outright view on the direction of While diversification may not necessarily protect against all volatility. For example, an investor who believes that the market risk, the historically negative correlation between forthcoming market environment is likely to have high levels implied volatility and equities may help stabilise returns of of uncertainty could invest in an asset that gives exposure to an equity portfolio. Although it can be counterintuitive, but one of the implied volatility indices. adding some implied volatility, whose returns can be very volatile, can lower the overall volatility of a diversified equity However, such an investment may have a negative return portfolio (see case study below). if implied volatility remains stable or even decreases, for example if the market outlook remains the same or becomes However, it is important to remember that diversification more stable. is not a panacea for all risk. For example, the magnitude of the implied volatility move is difficult to predict and therefore an investment may not fully offset any losses in the equity portfolio. Please note that you should not invest in any volatility related investment unless you understand the risks involved in such investments (taking independent Figure 5 professional advice as you deem appropriate), and you are Diversification effect capable of assuming such risks. Case Study: Using Implied Volatility as a diversification tool within a European equity portfolio It is important to note that during stable markets, an investment in Implied Volatility may suffer losses as market participants feel a greater sense of certainty in the markets. In these scenarios, an allocation to Implied Volatility within an equity portfolio may reduce any positive returns earned through the allocation to equities. Including Implied Volatility as part of an investment portfolio may helpt to reduce losses during turbulent markets and enhance the long term returns. 150 140 130 120 110 100 90 80 70 60 OcT 2005 OcT 2006 OcT 2007 OcT 2008 OcT 2009 OcT 2010 OcT 2011 Basket (90% SX5T + 10% VST1MT) sx5t Index These figures refer to past performance. Past performance is not a reliable indicator of future results. Source: Bloomberg, Barclays Capital. 18 th Oct 2005 31 st Oct 2011 8
What are some of the risks that should be considered? Investable implied volatility investments are proxies for expected volatility When investing in implied volatility investments it is important to remember that these are proxies for the market expected volatility. Furthermore, the VIX and VSTOXX implied volatility refer to the US equity markets and large cap European equity markets respectively, so may not reflect change in uncertainty in other regional markets, for example the UK equity market, or small cap European equities. The performance of implied volatility and implied volatility indices is unpredictable Implied volatility is in itself inherently volatile and may be affected by numerous factors including liquidity, supply and demand, market activity, regulatory intervention, civil action, natural disaster and other geopolitical circumstances. You should regard implied volatility linked products as high risk. An implied volatility index may be substituted in certain circumstances Investments linked to implied volatility indices will usually have the right to substitute the index in certain circumstances. Such action may negatively affect the value and performance of the investment. Furthermore, the investments are not guaranteed by an exchange and they do not confer any ownership of any exchange traded contracts. The policies of the relevant index sponsor The policies of the sponsor of the relevant volatility index and changes that affect the composition and valuation of the relevant volatility index could affect the amount payable on investment, linked to a volatility index and its market value. Investable implied volatility indices are subject to the roll yield Most implied volatility investments will be referenced to implied volatility indices. As mentioned earlier, these investments are likely to be subject to a roll yield effect. This effect may be positive or negative and can lead to significant divergence, either positive or negative, between the return of the indices and the theoretical level of the current implied volatility. 9
The Basics of Implied Volatility Which implied volatility index could be used? The popular indices are proxies for two of the main world equity markets and should be used as such: How do I invest in implied volatility? There are several ways of investing in implied volatility, but below is a brief summary of some common strategies for gaining exposure: VIX family of indices for the US equity market and VSTOXX family of indices for the European equity markets Furthermore, relative to the mid term indices, the short term indices tend to have a higher degree of sensitivity to implied volatility, but also tend to have a higher degree of roll yield. As a result the short term indices tend to be used as a tool for taking short-term directional views, whilst the mid-term indices tend to be used as diversification tools. Please note that negative roll yields could adversely affect the value of an Index and, accordingly, decrease any payment Investors might receive at maturity or upon redemption of an investment in a product linked to such an index. Option strategies: Some sophisticated investors may be able to implement various option strategies to extract the exact implied volatility required. However, this is not cost effective or practical other than for the more sophisticated institutional investors. Futures contracts: Managed futures eliminate the operational burden of managing an options strategy, but are best suited for institutional investors with the resources to meet investment minimums and manage derivatives contracts. Volatility funds: Some hedge funds implement various futures or options strategies. However, some of the funds may not be regulated in the relevant jurisdiction and may not be appropriate for a less sophisticated investor. Exchange traded products: A range of exchange traded volatility products are available. These are often in the form of notes or certificates. They provide an effective and easy to use investment, although the investor may be exposed to the issuer s credit risk. You should not invest in any volatility related investment unless you understand the risks involved of such investments (taking independent professional advice as you deem appropriate), and you are capable of assuming such risks. 10
Barclays has issued (ETNs) designed to provide investors with a new way to access this difficultto-reach market. ipath ETNs provide investors with convenient access to the returns of key implied volatility indices (less an investor fee), and may be one of the most convenient and cost effective means yet of gaining exposure. Please consult your financial adviser before considering an investment in ipath ETNs. An investment in ipath ETNs involves risks, including possible loss of principal. In addition, ipath ETNs do not pay any coupon. For a description of the main risks, see The Basics of ipath ETNs and the Risk Factors in the applicable prospectus. Please refer to www.ipathetn.eu ipath exchange traded notes (ETNs) ipath ALTERNATIVE ETNs Ticker Symbol Annual Fee* ISIN ipath VSTOXX Short -Term Futures ETN VSXX GY / VSXX LN VSXX IM 0.89% 0.89% DE000BC2KTT9 DE000BC2KZY6 ipath VSTOXX Mid -Term Futures ETN VSXY GY / VSXY LN VSXY IM 0.89% 0.89% DE000BC2KYE1 DE000BC2K050 ipath S&P 500 VIX Short -Term Futures ETN VXIS GY / VXIS LN 0.89% DE000BC1C7Q6 ipath S&P 500 VIX Mid -Term Futures ETN VXIM GY / VXIM LN 0.89% DE000BC1C7R4 * The investor fee is the Annual Fee times the applicable closing indicative value times the applicable daily index factor, calculated on a daily basis in the following manner: The investor fee on the inception date will equal zero. On each subsequent calendar day until maturity or early redemption, the investor fee will be equal to the Annual Fee times the closing indicative value on the immediately preceding calendar day times the daily index factor on that day (or, if such day is not an index business day, one) divided by 365. Find Your ipath www.ipathetn.eu 11
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