Specialist Strategies

Volatility Trading

In recent decades, volatility trading has emerged as a distinct asset class. Specialized hedge fund managers now focus on trading relative volatility strategies across various geographic regions and asset classes. For instance, Asia offers relatively cheap volatility pricing due to structured products with affordable embedded options, while North American and European markets tend to see higher implied volatility costs. Relative value volatility arbitrage aims to purchase low-cost volatility and sell more expensive options, accounting for time decay. These strategies may also involve active gamma trading adjustments based on market movements.

Investment Characteristics and Strategy Implementation

The field of volatility trading is explored through various examples and strategies. Notable strategies include time-zone arbitrage, capturing volatility spreads between regions, and cross-asset volatility trading. There are also outright long-volatility and short-volatility strategies. The market's most liquid volatility contracts are short-term VIX Index futures, subject to mean reversion. Different paths are taken to implement volatility trading strategies, using exchange-traded options, OTC options, VIX Index futures, or volatility and variance swaps, each with distinct advantages and risks. Long volatility strategies offer convex potential gains but come with counterparty risk and liquidity challenges, especially when using OTC contracts.

Risk Profile and Liquidity

Long volatility positioning offers positive convexity, making it valuable for hedging purposes. On the other hand, option premium sellers tend to achieve more stable returns in typical market conditions.

Relative value volatility trading can generate portfolio return alpha across various regions and asset classes.

The liquidity of instruments used for implementation varies. VIX Index futures and options are highly liquid. Exchange-traded index options are generally liquid but have limited tenors, while OTC contracts allow customization of maturities but are less liquid and less interchangeable among counterparties.

Leverage Usage

Volatility instruments inherently possess convexity, allowing for the potential of substantial gains with minimal initial risk. Despite the apparent nominal leverage in notional values, the asymmetrical characteristics of long optionality make this strategy attractive.

Benchmarking

Volatility trading is a specialized strategy with challenging benchmarking.

CBOE Eurekahedge offers several indexes, including the Long (and Short) Volatility Index (11 managers with long or short volatility positions), the Relative Value Volatility Index (comprising 35 managers), and the Tail Risk Index (comprising 8 managers, intended for market stress scenarios).

Reinsurance/Life Settlements

Hedge funds have expanded into insurance, reinsurance, life settlements, and catastrophe reinsurance. Insurance contracts involve payouts to policyholders upon specific insured events in exchange for periodic premiums. While the primary insurance market has existed for centuries, the secondary market has grown substantially.

Individuals can sell their insurance policies to third-party brokers who offer them as investments to hedge funds, providing potential uncorrelated returns based on differing life expectancy views. Hedge funds are also drawn to catastrophe risk reinsurance, improving liquidity and contract value. Reinsurance serves risk transfer, capital management, and solvency for insurance companies, offering hedge funds an avenue for uncorrelated return alpha.

Investment Characteristics and Strategy Implementation

Life insurance safeguards depend upon the policyholder's death, with the secondary market involving life settlements, which require extensive biometric and actuarial analysis. Hedge funds specializing in life settlements evaluate insurance pools for specific criteria and pay lump sums to policyholders, taking over premium payments in exchange for future death benefits. Success hinges on the present value of these benefits exceeding costs, and this strategy is uncorrelated with financial markets.

Catastrophe insurance, covering floods, hurricanes, and earthquakes, is highly distinctive and unrelated to financial markets. Reinsurance companies often partner with hedge funds for capital. Hedge funds in this space seek diversity, loan loss reserves, and premium income using valuation methods that consider weather patterns and worst-case loss potentials. Organized markets for catastrophe bonds and risk futures provide options for taking positions or hedging risk, with issuance and performance typically tied to seasonal events like the North American hurricane season.

Question

What key factors contribute to achieving an attractive and uncorrelated return profile when hedge funds invest in catastrophe reinsurance?

1. Obtaining policy diversity and minimizing geographic exposure.
2. Receiving a substantial buffer in loan loss reserves from the insurance company.
3. Combining geographic diversity, loan loss reserves, and premium income.

Solution

The correct answer is C.

It emphasizes combining factors, including geographic diversity, having a buffer in loan loss reserves, and ensuring an adequate premium income. These factors collectively contribute to achieving an attractive and uncorrelated return profile in catastrophe reinsurance.

A is incorrect. While policy diversity is mentioned, minimizing geographic exposure is not explicitly stated as a critical factor in the original statement.

B is incorrect. It focuses solely on the buffer of loan loss reserves but doesn’t consider the other factors mentioned in the statement.

Reading 38: Hedge Fund Strategies

LOS 38 (f) Discuss investment characteristics, strategy implementation, and role in a portfolio of specialist hedge fund strategies.