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Dispersion trading: many applications. Julien Messias (julien.messias@uncia-am.

com),
Uncia
Asset
Management
&
Michel-Hugo
Battistini,
Thomson
Reuters
(MichelHugo.Battistini@thomsonreuters.com),

http://eqderivatives.com/

Dispersion / Correlation trading may be set up in different ways. From the theoretical products
but illiquid such as Conditional Variance Swaps, or Variance Swaps, to vanilla options, we
focus on the different weighting schemes. We further investigate the impact of non-constant
weights and the application to Sector Indices.

Correlation smile, does it exist?


According to Avallaneda [2009], independently of the absolute correlation level, it seems that correlation
skew is overwhelmingly overpriced by implied parameters compared to the realized skew especially on
longer maturities. Correlation smile have been computed through index and single stocks realized
volatility skews.

Computing realized volatility skew:

Using Conditional Variance Swaps


The purest way to trade correlation skew should be done using conditional Variance Swaps, through the
following trade in a correlation skew seller way:

Sell an Index downside conditional variance swap conditional strike: 80%

Buy an Index ATM conditional variance swap conditional strike: 100%

Buy on each single stock a downside conditional variance swap conditional strike: 80%

Sell on each single stock an ATM conditional variance swap conditional strike: 100%

A conditional Variance Swap can be seen as a Variance Swap which is live only when the underlying price
is in the observation range. Pay-off of a long position is the following:
=

2
2
)
. . (

2.

It differs from a standard Variance Swap because of the Variance Adjustment term, and because of a
different strike. For example, in the short position on the Index downside conditional variance swap, the
realized variance would be accrued if and only if the closing price of day t or t-1 is (equal or) lower than
80% of the level of the Index at inception.
This instrument allows the investor to trade only the correlation skew part he is interested in. But they
are too illiquid and might be interesting only through a theoretical viewpoint. Therefore, lets focus on
tradable instruments and translate this position into vanilla Variance Swaps.

Using Variance Swaps


Variance Swaps only allow to trade the whole correlation smile, whereas it does not enable to trade a
correlation moneyness versus another as Conditional Variance Swaps would.
The well-known payoff is:
=

2
2
)
. (

2.

With

+ 1 .
252
. (
)

=1

One know, according to Bossu [2005], that many risk parameters of a Variance Swap position remain
constants, issued directly from the synthetic replication theory:
- with respect to spot price (caeteris paribus):
* Vega position

= 0 vanna null

* Cash Gamma position

2
.

=0

- with respect to the time (caeteris paribus):

* Cash Gamma position

2
.

=0

Moreover, Derman [1999] and Bossu [2005] proved thanks to the replication method that Variance Swaps
are a positive function with respect to the asset skew magnitude: the steeper the skew, the more expensive
the Variance Swap.
Using a Black Scholes calculation framework allows variance swap pricing through replication method

for maturity T: = [ . (

Different schemes of dispersion trades:


The first issue is about the kind of dispersion to setup. Many different schemes to choose among:
-

Vega weighted flat dispersion trade, for which Vega sizes might be rounded as following: lets use

the following weight for each i belonging to the Index: .


usually lower than due to

correlation effect.
Then, the following weighted scheme becomes:

= . .
=1

=1

Bossu [2005]


. ( .

2
2
)+
=
. (

2.
2.

2
. (
2 )

=1

2
2

2
. [(

) + . 2 . (
2 )]
2

=1

2
. [(
) + . (1 + 2 . (
2 ))]
2

=1

=1

=1

) + (1 + 2 . 2 2 . 2 )]
. . [(
2

) + (1 + 2 . 2 1)]
. . [(
2

=1

2
2
) ]
. . [ . ( ) (
2

=1

This weighting scheme enables to analyze more easily the PNL.


Lets use the proxy formula by Allen, Einchcomb and Granger:

2 . (=1 . )
. . [ . ( )
]
2

. (=1 . )
=1

The best scenario in this case is a low realized correlation and high stock realized volatilities. This scenario
is quite unlikely as correlation and volatilities are two very correlated assets except seasonality
phenomena such as results releases by companies.

If it is assumed that each is volatility moves by

being what is implied by the vega weighted flat

scheme, what is the impact on the Index variance:

= 2 . ( +

2
,

=1

=1

2
,
= 2 . 2 +

. 2 . 2 +

=1

) + .

=1 =1

=1

=1 =1

.
=1 =1

. { 2 . 2 +
=1

1
2

. 2 . 2 + . }
=1

=1 =1

. { 2 . 2 + . }
=1

=1 =1

2
2
,
=
+

Then, a move of

. 2 . 2 + . +

=1 =1

=1 =1

) . ( ( +
)

. . ( +

2
,
= { 2 . 2 + . } +
=1

2
1
2
. 2
+ 2
.
= ( + 1)

on each stock i volatility entails a 1point move on the Index volatility.

vega flat dispersion trade, meaning that at inception, the sum of the single stocks vegas matches
the index vega

It consists in the following weighting scheme: =1 = . =1


Long Variance swaps PNL are the following:
=

2
2
. (

)
2.
.
. (2 2 )
2.

Long Dispersion PNL becomes:


=

.
2
2
)+
. (

. (2 2 )
2.
2.

Vega flat strategy may be split between a Vega Weighted Flat strategy plus a Long position on the Index
Variance Swap. This bias is implied because correlation effect is not taken into account in the weighting
scheme. Using the latter, the long dispersion investor may lose money even if the realized correlation is
lower than the implied one, especially if realize variance on the Index is far lower than the implied one.

theta & gamma flat dispersion trade. Under a null risk-free rate framework (cf Assumptions), those
two strategies are very close. In practice, the difference between both is the difference between
the risk free rate and the return of the stocks over the period we consider.
*Gamma flat: the Gamma of the Index is worth the sum of the Gammas of the components. In a
delta-hedged framework, the trader is immune against any move in the stocks but keeps a Vega
position.
*Theta flat: the Theta of the Index is worth the sum of the Thetas of the components. It results
with a short Vega position and a short Gamma position.

Impact of non-constant weights


The market weighted property of the Index suggests an impact of the non-constant weights on the
correlation behavior, compared to a constant weights assumption. Lets try to estimate this impact on
dispersion trades (: realized volatility; K: strike).
As an Index is considered as a Market-Weighted Basket of Stocks, the following relationships stand , :

1
. , . ,

=1

, = %, =

1
. .
. , ,

Then lets differentiate a position where we do not change the weights of the assets, and a position where
we adjust at each closing day the vega positions, due to the change in %weights. Volga PNL impact must
be avoided.
Using Variance Swaps, assuming being any %weight for stock i meaning that:
=
{ = .

0 =vega notional on the Index Variance Swap


Lets use a discrete timeframe, 0 being the inception of the Dispersion Variance Swap trade:
0

At 0 , the vega for each stock i is:

The final PNL of the Variance Swap between 0 and T is:

2.0

. ,0

0
252

) 02 ]
. .[
. 2 (
2. 0 ,0
1
=1

At 1 , we adjust the Vega position due to the move in weight. The adjustments are made with respect to
0 in order to avoid any Index Volga linked PNL. Therefore:
*we sell for stock i the Variance Swap maturity T (1 day shorter than the Variance Swap traded in 0 in

order their maturities to match) with strike 1 , for a vega notional of 0 . 1 . ,0


0

*we buy for stock i the Variance Swap maturity T with strike 1 for a vega notional of 0 . ,1
Then, the final position due to position initiated in 0 , and closed in 1 is:

=1

=2

0
252
1
252
252

) . 2 (
)]
. .[
. 2 ( ) + (12 02 ) + (

2. 0 ,0
0

1
1

Generalizing for n stocks and T days, the PNL of the long volatility position of the Dispersion Trade is:

=1 =1

=1

=+1

0
252
,
252
252

2
2
)+(
) . 2 (
)]
.
.[
. 2 (
) + (,
,1

2. ,1 ,1 ( 1)
,1
( 1)
1

The PNL of the Dispersion trade with volatile weights is:

0
252
,
0
252
,
252
252

2
2
. [0,

. (
)] +
.
.[
. 2 (
02 ) + (

) . 2 (
)]
) + (,
2. 0,

1,
2. ,1 ,1 ( 1)
,1
( 1)
1
=1

=1 =1

=1

=+1

Through this strategy, the PNL difference due to weight changes is:

=1

=+1

0
252
,
252
252

2
2

)+(
) . 2 (
)]
. (,1 ). [
. 2 (
) + (,
,1

2. ,1
( 1)
,1
( 1)
1
=1 =1

Assuming the existence and the use of 1-day Variance swaps, each day PNL would be:

0
1,
0
1,
2
2
. [0,
252. 2 ( )] +
. ,0 . [252. 2 ( ) 0,
]
2.

2.

0,
0,
0,
0,

=1
0 1

0 1

Generalizing for T days:

1
,
1
,
2
2

. [1,
252. 2 (
)] +
.
. [252. 2 (
) 1,
]
2. 1,
1,
2. 1, ,1
1,

=1
=1

Through this strategy, the PNL difference due to weight changes is:

=1 =1

1
,
2
. (,1 ). [252. 2 (
) 1,
]
2. 1,
1,

Uncia AM is the French specialist of High Growth management style. For more information, go to our
website www.uncia-am.com or contact@uncia-am.com