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**VARIANCE SWAP BASICS Equity Derivatives Strategy
**

A variance swap is an over-the-counter derivative contract in which two parties agree to buy or sell the realized volatility of an index or single stock on a future date—the swap-expiration date—for a pre-determined price, the swap-strike. The payoff for an investor who buys variance using a swap is equal to the difference between the realized and strike variance, multiplied by the notional amount of the swap: [$ Notional * (Realized Volatility2 – Strike Level2)]. An investor who sells variance would receive the opposite payoff: [$ Notional * (Strike Level2 – Realized Volatility2)]. Variance swap vega is the dollar-change in swap value for each percentage-point movement in volatility. The vega of the swap equals twice the volatility times the notional amount of the swap: [2 * Volatility * $ Notional]. Variance swaps have been actively traded over-thecounter for more than 8 years, and more recently (since 2004) have begun to trade on the CBOE.1 Portfolio managers can enter into variance swaps easily. The investor specifies which underlying index to use and the duration of the swap contract. He then must determine whether he wants to buy variance (so that he will profit from any increase in the volatility of the index above the swap strike) or sell it (so that he will profit from any decrease in volatility below the swap strike). Finally, the investor must decide the type of volatility exposure. Typically, investors choose “vega exposure”—a $100,000 vega exposure means that the swap value will change by $100,000 for each percentage point change in the volatility of the underlying index. Once the investor has an ISDA master agreement in place, he can obtain a quote and trade.

April 7, 2005

Marko Kolanovic (212) 272-1438 mkolanovic@bear.com Gary Semeraro (212) 272-4800 gsemeraro@bear.com

**EXAMPLE VARIANCE SWAP AND PAYOFF CALCULATION
**

Realized volatility is used to determine the swap payoff at maturity. This measure is calculated from daily index closing prices in a straightforward and standardized way.2 The payoff calculation from an example 30-day short S&P 500 variance swap entered into on Feb 23, 2005 is shown below. The swap valuation date was April 7, 2005, the notional swap vega amount was $100,000, and the swap strike price (ask) is 11. The swap settlement value was 9.8701, which was below the swap strike of 11; the contract was closed at a gain of $107,183. Essentially, as volatility decreased by roughly 1 volatility point, the investor gained $107,183. Fig. 1: Swap Settlement for 30-Day S&P 500 Variance Swap

Day Trade 1 2 3 4 5 Date 02/23/05 02/24/05 02/25/05 02/28/05 03/01/05 03/02/05 Index Log Return Log Return 1,190.8 --1,200.2 0.7863% 0.0062% 1,211.4 0.9264% 0.0086% 1,203.6 -0.6435% 0.0041% 1,210.4 0.5642% 0.0032% 1,210.1 -0.0273% 0.0000%

2

. . .

. . .

. . .

. . .

. . .

Realized Vol Calculation Sum of Log Returns Squared Divided by number of returns (30) Square Root Multiplied by square root of 252 Swap settlement value Swap Payoff Strike Vega Notional Payoff

0.1160% 0.0039% 0.6218% 9.8701% 9.8701

23 24 25 26 27 28 29 Valuation

03/29/05 03/30/05 03/31/05 04/01/05 04/04/05 04/05/05 04/06/05 04/07/05

1,165.4 1,181.4 1,180.6 1,172.9 1,176.1 1,181.4 1,184.1 1,191.1

-0.7625% 1.3679% -0.0694% -0.6518% 0.2725% 0.4471% 0.2266% 0.5953%

0.0058% 0.0187% 0.0000% 0.0042% 0.0007% 0.0020% 0.0005% 0.0035%

11 $ 100,000 $ 4,545 $ 107,183

Source: Bear Stearns Equity Derivatives Strategy, Bloomberg.

1

3-month variance futures now trade on the CBOE. The first documented variance swap traded on the FTSE Index in 1993. 2 To calculate this, one first takes the index’s daily log-returns; then the sum of the squares of the returns is divided by the number of daily-returns measured. This volatility number is multiplied by the square root of 252 to annualize the measure, and by 100 to return a number in volatility points as opposed to a decimal number. This resulting number is the realized volatility over the life of the swap, and is the swap settlement value.

Bear Stearns Equity Derivatives Strategy

Page 1

**Variance Swaps: An Introduction
**

The payoff of a volatility swap is directly proportional to realized volatility; the profitability of a variance swap, however, has a quadratic relationship to realized volatility. These relationships are shown in Figure 2. Fig. 2: Payoff of Long Variance and Volatility Swaps Struck at 20 Volatility Points; $100,000 Notional Vega

$4,000,000

$3,000,000

Variance Swap Volatility Swap

$2,000,000

$1,000,000

Payoff

$0 $(1,000,000) 5 10 15 20 25 30 35 40

$(2,000,000)

$(3,000,000)

Realized Volatility (vol. points)

Source: Bear Stearns Equity Derivatives Strategy, Bloomberg.

Since a long variance swap gains more than a simple volatility swap when volatility increases and loses less than a volatility swap when volatility decreases, variance swap levels are typically quoted above the expected level of future realized volatility (ie: above option-implied volatility). This spread between variance and volatility is called convexity. Examples of Bear Stearns’ indicative levels for S&P 500 and Nasdaq 100 variance swaps are shown below.3 For example, on April 7th, an S&P 500 (SPX) variance swap with Dec 05 expiration was bid at 14.4 and offered at 15.4. A sample term sheet is shown as well. Fig. 3: Example Quotes for Index Variance Swaps (left); Sample Term Sheet (right)

S&P 500 INDEX VARIANCE SWAP March 4, 2005

4/7/05

SPX May'05 Jun'05 Sep'05 Dec'05 Dec'06 FUTURES Expiry Expiry Expiry Expiry Expiry 1186 @ 9:46 -- 11.80 / 12.80 -- 12.90 / 13.90 -- 13.80 / 14.80 -- 14.40 / 15.40 -- 15.90 / 16.90

Transaction Summary:

Buyer enters into a variance swap, under which it • • Receives a Payoff at Maturity if the Volatility, as calculated on the Valuation Date, is greater than the Strike. Pays a Payoff at Maturity if the Volatility, as calculated on the Valuation Date, is lower than the Strike.

General: Seller: Buyer: Trade Date: Valuation Date: Payment Date: Volatility Units (USD per point): Variance Units (USD per point): Underlying Index: Strike: Payoff at Maturity: Bear Stearns International, Limited (“BSIL”) March 4, 2005 April 15, 2005 3 Exchange Business Days following the Valuation Date USD 100,000 4,385.9649 (Equal to {Volatility Units/ (2*Strike) } S&P 500 Index (“SPX”) 11.4% Variance Units * [ (Volatility)2- (Strike)2] If such amount is a positive number, then Seller shall make a payment to Buyer

4/7/05

NDX May'05 Jun'05 Sep'05 Dec'05 Dec'06 FUTURES Expiry Expiry Expiry Expiry Expiry 1490 @ 9:54 -- 17.00 / 18.00 -- 18.25 / 19.25 -- 19.50 / 20.50 -- 20.25 / 21.25 -- 21.50 / 22.50

Volatility:

If such amount is a negative number, then Buyer shall make a payment equal to the absolute amount to Seller

252 x

100*

∑ (Re turn( i ))

i =1

n

2

n

, where:

⎡ ( Indexi ) ⎤ Return(i) = ln ⎢ ⎥ ⎣ ( Indexi − 1) ⎦

252 = Annualization Factor n = Number of observations excluding the initial observation on Trade Date, but including the Valuation Date Indexi = The closing level of the Underlying Index i business days from the Trade Date except for Index0 which shall equal the closing level on the Trade Date and Indexn which shall equal the special quotation of the Underlying Index on the Valuation Date. Documentation: Currency: Exchange: Market Disruption: Collateral: As per ISDA USD New York Stock Exchange Postponement Upfront: Subject to portfolio margin calculation agreed upon Mark-to-Market: As per ISDA

Source: Bear Stearns Equity Derivatives Strategy, Bloomberg.

3

This historical, real-market example is to be used for illustrative purposes only.

Bear Stearns Equity Derivatives Strategy

Page 2

**Variance Swaps: An Introduction
**

VARIANCE SWAP STRATEGIES

In this section, we list some common applications of variance swaps. Hedging Equity Returns Variance swaps are often used for portfolio protection. Index implied volatility (and therefore, variance) is negatively correlated to equity returns. In addition, the payoff of a long variance swap increases more rapidly than equity returns decrease. Thus, variance swaps can be used as crash-protection, insulating a portfolio from very negative equity market performance. Figure 4 shows the relationship between monthly changes in 30-day S&P 500 variance (as measured by the VIX Index) and monthly changes in the S&P 500 Index. Fig. 4: Relationship between the S&P 500 and VIX Index; 5 Years of Monthly Returns

120% 100% 80% 1M VIX Change (%) 60% 40% 20% 0% -20% -20% -40% 1M S&P 500 Return (%)

R2 = 64%

-15%

-10%

-5%

0%

5%

10%

15%

20%

Source: Bear Stearns Equity Derivatives Strategy, Bloomberg.

Volatility Relative Value and Directional Strategies Variance swaps can also be used in volatility-based relative value trades. For example, an investor can buy S&P 500 variance and sell a similar amount of Nasdaq 100 variance. The trade will be profitable if NDX volatility decreases relative S&P 500 volatility, or if S&P 500 volatility increases less than Nasdaq 100 volatility. This trade was very profitable in the months following the tech bubble burst in 2000. During this period, the weight of technology stocks in the Nasdaq 100 decreased significantly; this ultimately caused Nasdaq 100 Index volatility to decrease significantly as well, especially relative to S&P 500 Index volatility. Fig. 5: 3M S&P 500 and Nasdaq 100 Index Volatility; 2000 – Present

100%

S&P 500 and Nasdaq 100 3 Months Volatility

90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Nasdaq 100 3M Volatility S&P 500 3M Volatility

Sep 00

Aug 01

Jul 02

Jun 03

May 04

Apr 05

Source: Bear Stearns Equity Derivatives Strategy, Bloomberg.

Bear Stearns Equity Derivatives Strategy

Page 3

**Variance Swaps: An Introduction
**

Credit and Equity Volatility Relative Value A company’s credit risk (default risk) is related to its stock price and equity volatility. A decline in stock price usually leads to an increase in both equity volatility and credit risk (as measured, for instance, by the price of a credit default swap). The charts below illustrate the correlation between credit risk (as measured by the spread between BAA-rated US corporate 30-year bonds and the equivalent treasury rate) and volatility in the S&P 500 Index (as measured by the VIX Index) since April 2000. The correlation between these two measures was 75% during this period. Fig. 6: Correlation between Credit Risk (Corporate Spread) and Equity Volatility (VIX)

45 40 35 30 VIX 25 2 20 15 10 5 0 Apr-00 1.5 2.5 BAA Corporates Spread (%) 3 3.5

50 40 30 VIX 20 10 0 R2 = 56%

**VIX BAA Corporates Spread
**

1 0.5 Mar-01 Feb-02 Jan-03 Dec-03 Nov-04

1

1.5

2 2.5 BAA Corporates Spread (%)

3

3.5

Source: Bear Stearns Equity Derivatives Strategy, Bloomberg.

An investor could use a variance swap to hedge the credit risk of a basket of corporate bonds because of this relationship. A variance swap could also be used in a credit versus equity volatility relative value trade. Credit spreads and equity volatility have been positively correlated on the single-stock level; thus, single-stock variance swaps could be used for company-specific capital structure trades. Selling Equity Risk The implied volatility of the S&P 500 has traded at a persistent premium to realized volatility, as a result of supply/demand inefficiency; there has consistently been excess demand for putprotection in the S&P 500. An investor can capitalize on this market inefficiency by selling variance swaps to capture the resulting premium. An investor can create several types of longcash, short-variance portfolios that have S&P 500 “variance bonds.” An example Notional Variance Bond is created by lending $100M at the risk-free rate and selling $20,000 notional variance; an example Vega Variance Bond is created by lending $100M at the risk-free rate and selling $800,000 notional vega variance. By modifying the amount of variance sold, an investor can tune the degree of leverage for a given strategy to prevent large losses should the volatility spike. Historical returns for these strategies are shown in the table below. Fig. 8: 15-Year Historical Returns of Sample S&P 500 Variance Bonds

Return S&P 500 Index 9.3% Notional Var Bond 16.5% Vega Var Bond 15.7% Risk Information Ratio 15.1% 0.62 9.0% 1.83 6.6% 2.38

Source: Bear Stearns Equity Derivatives Strategy, Bloomberg.

Bear Stearns Equity Derivatives Strategy

Page 4

Variance Swaps: An Introduction

Disclaimer This communication is being provided for informational purposes only and is not intended as a recommendation or an offer or solicitation for the purchase or sale of any security referenced herein. It is being provided to you by the trading desk referenced above as part of the Firm’s proprietary trading activities and on the condition that it will not form the primary basis for any investment decision. Any views expressed herein are those of the individual author and may differ from those expressed by other Bear Stearns departments, including any of the Bear Stearns research departments. The author of this communication may receive compensation based in part on Bear Stearns’s proprietary trading revenues. Bear Stearns and its affiliates may have positions (long or short), effect transactions or make markets in securities or options on such securities referenced herein. Bear Stearns may have underwritten securities for, or otherwise have an investment banking relationship with, issuers referenced herein. The information contained herein is as of the date referenced and Bear Stearns does not undertake an obligation to update such information. Bear Stearns has obtained all market prices, data and other information from sources believed to be reliable although its accuracy or completeness cannot be guaranteed. Such information is subject to change without notice. The securities mentioned herein may not be suitable for all investors. Clients should contact their Bear Stearns representative at the Bear Stearns entity qualified in their home jurisdiction to place orders or for further information. Bear, Stearns & Co. Inc. is a member of the NYSE, NASD and SIPC. Copyright © 2005 Bear, Stearns & Co. Inc. All rights reserved. Note: Options strategies are complex and subject to substantial risks and may not be right for every investor. Individuals should not enter into option transactions until they have read and understood the basic option disclosure document issued by the options exchanges and the Options Clearing Corp. “Characteristics and Risks of Standardized Options.” Past performance is not indicative of future results. Supporting documentation will be supplied upon request.

Marko Kolanovic

mkolanovic@bear.com

Bear Stearns Equity Derivatives Strategy

Page 5

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