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Equity Derivatives
Overview
JPMorgan’s European Equity JPMorgan’s Cross Sectional Model uses a snapshot of the relationship between
Derivative Strategy Group uses a current implied volatility and other independent variables for a broad group of
similar Cross Sectional Model. companies to construct a multi-factor regression. In effect, the model calibrates how
implied volatility across the market is impacted by various factors at the present time,
Please see “Equity and Derivatives and highlights when single stocks deviate from the broader pattern. The factors used
Markets Weekly Outlook” 21 Nov in the model are:
2005 for details on the European
model.
• Beta
• Market capitalization
• CDS spread
Exhibit 1 below shows a comparison between the model and actual implied volatility
for the company universe that is liquid in both equity derivatives and CDS.
Companies above the line have rich implied volatility vs. the model; companies
below the line have cheap implied volatility vs. the model.
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Eric Beinstein (1-212) 834-4211 Corporate Quantitative Research
eric.beinstein@jpmorgan.com November 17, 2006
*Note that several companies that are in the process of a leveraged buy-out have high model volatility relative to actual volatility, as the
model does not explicitly consider LBOs. In these cases, the model should be overlaid with a “sensibility” check to incorporate other
factors, such as LBOs, that impact volatility.
Source: JPMorgan, data as of 3rd October 2006
In practice, our Cross Sectional Report is not one model but many models. Implied
volatility under each model may depend on some or all of the factors above and have
differing sensitivity to each. We discuss the process to select relevant factors for
each model in detail later on in this note.
In contrast, Sector Models are often good at determining rich/cheap volatility within
a sector, but they can miss broader market context (e.g., KB Homes currently appears
rich vs. its sector, but the sector overall looks cheap to the market). For this reason,
we produce both a Market Model for the entire liquid universe and 10 individual
Sector Models (one each for the ten GICS sub-sectors). As discussed herein, we find
that using both models together produces the best results.
Notably, the Market Model is produced with and without CDS spreads as a factor.
The Market Model (with CDS) has fewer companies. Due to the limited number of
companies where CDS is liquid, we do not include CDS in the Sector Models, as it
would too severely limit the number of model observations, in our view.
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Eric Beinstein (1-212) 834-4211 Corporate Quantitative Research
eric.beinstein@jpmorgan.com November 17, 2006
Realized volatility: Implied volatility is strongly related to both long term (12M)
and short term (1M) realized volatility. Long term realized volatility gives investors
a gauge of average volatility, whereas short term realized volatility reflects more
recent trends and is generally more relevant for shorter term options.
Exhibit 2: 6M Implied Volatility (y-axis) and 1M Realized Vol (x-axis) – broad market liquid
universe
60
50
40
30
20
10
0
0 10 20 30 40 50 60 70 80
Source: JPMorgan
Exhibit 3: 6M Implied Volatility (y-axis) and Market Capitalization in Exhibit4: 6M Implied Volatility (y-axis) and LN Market Capitalization
bn (x-axis) – broad market liquid universe (x-axis) – broad market liquid universe
60 60
50 50
40 40
30 30
20 20
10 10
0 0
0 200 400 21 23 25 27
Source: JPMorgan
Beta with S&P500: Beta measures stock price sensitivity to movements in the
market. As such, higher volatility is often associated with higher betas.
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Eric Beinstein (1-212) 834-4211 Corporate Quantitative Research
eric.beinstein@jpmorgan.com November 17, 2006
Exhibit 5: 6M Implied Volatility (y-axis) and Stock Beta vs. S&P 500 (x-axis) – broad market liquid
universe
60
50
40
30
20
10
0
0 0.5 1 1.5 2 2.5 3
Source: JPMorgan
Stock Price Return: Implied volatility is typically inversely related to stock price
returns, with negative price returns generally being associated with higher implied
volatility, all else equal. One reason for this phenomenon may be the leverage effect.
This theory states that as the stock falls, the market value of the equity typically falls
faster than the market value of the debt, causing the debt/equity ratio to rise and the
risk of the stock to increase. Another reason is a slide down the equity skew,
whereby higher implied volatility may be observed at lower prices, even absent a
parallel shift in the volatility curve.
Additionally, we note that higher implied volatility is also observed for large upside
stock returns. This may be due to fears of a reversal, or simply because large past
returns are indicative of a more volatile stock. Because large stock price movements
both up and down can increase implied volatility, we use the absolute value of stock
price returns in the model (Exhibit 6).
Exhibit 6: 6M Implied Volatility (y-axis) and stock price return (x-axis) – broad market liquid
universe
80
70
60
50
40
30
20
10
0
-35 -25 -15 -5 5 15 25 35
Source: JPMorgan
CDS Spread: CDS spread is a measure of credit risk. The higher the spread, the
more premium a protection buyer is willing to pay for protection against a company's
default, presumably due to a higher degree of risk that will also be reflected by
implied volatility. We have chosen 5yr CDS as it is the most liquid of the tenures.
We expect that increasing attention to cross-asset models that link CDS spreads to
implied volatility may reinforce the theoretical correlation between the two markets.
Among these models, the most straightforward and transparent include JPMorgan’s
“Cross Asset Relative Performance Report”, which publishes univariate regressions
between the two markets daily. Other applications include Reduced-form models,
which use the insight that both implied volatility for deep out-of-the-money options
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Eric Beinstein (1-212) 834-4211 Corporate Quantitative Research
eric.beinstein@jpmorgan.com November 17, 2006
and CDS spreads can be used to derive a probability of default. Finally, Structural
models view corporate credit as the combination of a long risk-free security and short
a put struck at the value of the firm’s assets. As such, the credit value is contingent
on asset volatility, which can be approximated using equity volatility.
Exhibit 7: 6M Implied Volatility (y-axis) and 5 year CDS (x-axis) – broad market liquid universe
60
50
40
30
20
10
0
0 100 200 300 400 500 600 700 800
Source: JPMorgan
The rolling 1yr R-squared of these regressions for each factor are shown in Exhibit 8.
We can use this process to identify whether each factor has a significant correlation
with implied volatility. Our rule is that if the average R-Square over the last year is
less than 0.15, the factor will be deemed insignificant and be rejected. For example,
although it may seem that Stock Return 1M is decreasing in significance, the average
R-Square is still larger than 0.15. Exhibit 8 shows that all our factors were accepted
after the first linear regression filter.
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Eric Beinstein (1-212) 834-4211 Corporate Quantitative Research
eric.beinstein@jpmorgan.com November 17, 2006
8D: R-Sq Stock Return 1M (0.18) 8E: R-Sq Stock Return 12M (0.20) 8F: R-Sq CDS Spread 5Y (0.44)
In addition, we wish to determine whether the sign of each factor is the same over
time. For example, if stock price returns were strongly correlated with implied
volatility, but the direction of the impact changed over time (e.g. if high returns were
sometimes associated with an increase in implied volatility and other times were
associated with a decrease), this factor would not be especially helpful in predicting
implied volatility, despite the high correlation. Exhibit 9 shows the t-statistic of each
factor. The t-statistic measures the coefficient of the factor divided by its standard
deviation. All of the t-statistics below are consistent with regard to sign, and are well
above the threshold for determining statistical significance.
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Eric Beinstein (1-212) 834-4211 Corporate Quantitative Research
eric.beinstein@jpmorgan.com November 17, 2006
9D: T-Stat Stock Return 1M 9E: T-Stat Stock Return 12M 9F: T-Stat CDS Spread 5Y
Exhibit 10: Absolute Correlation Matrix for remaining factors after Linear Regression filter
Stock_Return_1 Stock_Return_12
Hist_Vol_1M Hist_Vol_12M Beta Market_Cap M M CDS_5Y
CDS_5Y 1.00
Source: JPMorgan, data as of 3rd October 2006
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Eric Beinstein (1-212) 834-4211 Corporate Quantitative Research
eric.beinstein@jpmorgan.com November 17, 2006
Exhibit 11: Coefficients statistic and P-Value of Multiple-Regression after Correlation filter
(1Y Avg) Stdev of
R-Sq=0.80 (1Y Avg) Coefficient Coefficient p-Stat
Constant 46.71 11.880 0.010
Hist_Vol_1M 0.30 0.130 0.007
Beta 6.13 2.050 0.008
Market_Cap (1.50) 0.450 0.019
Stock_Return_1M 0.04 0.174 0.324
Stock_Return_12M 0.02 0.036 0.227
CDS_5Y 0.02 0.004 0.000
Source: JPMorgan, data as of 3rd October 2006
Another multiple regression is then performed with the remaining five factors. This
time none of the factors are eliminated based on the P-Value threshold of 0.30.
This multi-step process for factor selection and coefficient designation is performed
for each model on a quarterly basis. This rebalancing process allows the model to
adjust for factors and factor weights that have become more or less important as the
market changes. In between the rebalancing periods, the model is updated daily
using close of business pricing.
Section 1: Summary
A one page summary of the top 15 richest and cheapest implied volatility in the
liquid equity derivatives universe ranked by the Sector Model z-score. Companies
on this list must also have Market Model z-score that “agrees” with (is the same sign
as) the Sector Model. Exhibit 13 shows an excerpt of the summary table for rich 3M
implied volatility.
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Eric Beinstein (1-212) 834-4211 Corporate Quantitative Research
eric.beinstein@jpmorgan.com November 17, 2006
Source: JPMorgan
If the model volatility is lower than the actual volatility, actual volatility appears rich
and the z-score will be positive. The Sector Model is telling us that the actual
implied volatility is 2.22 standard deviations too high vs. the Consumer Cyclical
model volatility of 34.2%. Additionally, the Market Model also calculates that RAD
implied volatility is expensive, at 1.23 standard deviations too high versus the model
implied volatility of 33.7%.
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Eric Beinstein (1-212) 834-4211 Corporate Quantitative Research
eric.beinstein@jpmorgan.com November 17, 2006
• Market Model (no CDS): Regression of all companies with liquid options.
CDS is not used so the universe is larger but the model fit is slightly worse.
Buy volatility when z-score > 2.0, sell volatility when z-score < -2.0.
• Market Model (w/ CDS): Regression of all companies with both liquid
options and liquid CDS. The inclusion of CDS reduces the number of
companies in the universe. Buy volatility when z-score > 2.0, sell volatility
when z-score < -2.0.
• Sector Model: 10 separate regressions, one for each GICS sector. CDS is
not included. Buy volatility when z-score > 2.0, sell volatility when z-score
< -2.0.
• Sector Model + Market Model (no CDS): As above, but enter trade when z-
score > 2.0 or < -2.0 for both the Sector Model and Market Model.
• Simple Model: Regression universe is the same as the Market Model. Buy
volatility when implied volatility is less than realized volatility and sell
volatility when implied volatility is greater than realized volatility.
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Eric Beinstein (1-212) 834-4211 Corporate Quantitative Research
eric.beinstein@jpmorgan.com November 17, 2006
spread of one vol. The return percentages listed treat volatility as a security and
simply observe its return (i.e. it is not a variance return). Returns are non-annualized.
Exhibit 15: Buy and sell volatility: Backtest results for five different models
Info Ratio Total Avg Info Ratio
Implied Vol Avg Ret Stdev Ret Ret Trades % Good Vega Stdev Vega Vega Model
1M 0.3% 31.8% 0.01 189,472 51.3% 0.0 0.12 0.04 Simple
1M 12.6% 39.9% 0.31 614 64.8% 5.7 22.34 0.25 Market (w/ CDS)
1M 12.2% 35.4% 0.34 3,783 69.7% 8.9 24.47 0.36 Market (no CDS)
1M 11.8% 31.7% 0.37 3,440 68.6% 8.4 22.53 0.37 Sector
1M 15.1% 33.7% 0.45 2,163 73.0% 11.2 26.43 0.42 Sector + Market (no CDS)
Both Market and Sector Models outperform the “simple” strategy. In terms
of information ratio, the simple strategy significantly underperforms for both 1M
and 3M trading strategies. The simple strategy does a bit better for 6M
strategies, having the second highest information ratio, but also has the lowest
average return.
The Sector Model + Market Model outperforms the Sector Model alone.
For all maturities, requiring a joint "signal" from both the Market Model and
Sector Model to enter a trade increases average returns and increases the
information ratio. This additional step does, however, reduce the number of
trades over the period by about a third.
Adding CDS to the Market Model is better for longer dated options.
Relative to the Market Model, we find no clear benefit from including CDS for
valuing shorter dated options, as average returns and information ratios are
lower for both 1M and 3M strategies. 6M strategies, however, outperform in
terms of both risk and return when CDS is used in the model. This makes sense
to us given that 5yr CDS is used, which has a stronger theoretical link to longer
dated options.
Average returns for all models is positive. While this is clearly a good thing,
it is difficult to draw any conclusions, as the absolute level of returns is driven
by the market environment as well as the model output. For example, the
backtest period experienced low volatility and selling volatility was generally
profitable. We cannot ascertain from Exhibit 15 whether the profits we observe
are due to judicious trade selection or a higher tendency to sell volatility. We
also can make no claims about the ability of the model to identify buying versus
selling opportunities. For this reason, we decompose the results into sell
volatility (Exhibit 16) and buy volatility (Exhibit 17) below.
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Eric Beinstein (1-212) 834-4211 Corporate Quantitative Research
eric.beinstein@jpmorgan.com November 17, 2006
The Cross Sectional Models perform better for both selling and buying
volatility. All models improve average returns versus the simple strategy for
selling and buying volatility, and also improve the risk/return in most cases. In a
market environment when selling volatility is generally profitable, we should
bring our focus to the results to the relatively stronger performance of the model
to the simple strategy,
Exhibit 16: Sell volatility only: Backtest results for five different models
Implied Vol Avg Ret Stdev Ret Sharpe Ret Total Trades % Good Avg Vega Stdev Vega Sharpe Vega Model
1M 3.61% 32.31% 0.11 126,671 64.6% 0.0 0.12 0.13 Simple
1M 16.0% 34.4% 0.47 430 74.4% 6.6 23.19 0.28 Market (w CDS)
1M 14.5% 34.1% 0.43 3,255 75.2% 10.1 25.19 0.40 Market (no CDS)
1M 14.7% 30.9% 0.48 2,950 74.9% 9.8 23.44 0.42 Sector
1M 16.4% 32.6% 0.50 2,044 76.0% 11.9 26.48 0.45 Sector + Market (no CDS)
Exhibit 17: Buy volatility only: Backtest results for five different models
Implied Vol Avg Ret Stdev Ret Sharpe Ret Total Trades % Good Avg Vega Stdev Vega Sharpe Vega Model
1M -11.1% 32.3% (0.34) 62,801 25.4% (0.0) 0.12 (0.29) Simple
1M 4.4% 49.7% 0.09 184 42.4% 3.6 20.09 0.18 Market (w CDS)
1M -2.2% 39.5% (0.06) 528 35.2% 1.3 17.65 0.07 Market (no CDS)
1M -5.9% 30.4% (0.19) 490 30.8% (0.2) 13.12 (0.01) Sector
1M -7.2% 43.4% (0.16) 119 20.2% (0.8) 22.60 (0.03) Sector + Market (no CDS)
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Eric Beinstein (1-212) 834-4211 Corporate Quantitative Research
eric.beinstein@jpmorgan.com November 17, 2006
Risks to Strategies
Option Buyer. Options are a decaying asset, and investors risk losing 100% of the
premium paid.
Call Option Sale. Investors who sell uncovered call options have exposure on the
upside that is theoretically unlimited. Investors who sell calls but also own the
underlying stock will have limited losses should the stock rally.
Put Sale. Investors who sell put options will own the underlying stock if the stock
price falls below the strike price of the put option. Investors, therefore, will be
exposed to any decline in the stock price below the strike potentially to zero, and
they will not participate in any stock appreciation if the option expires unexercised.
Call Overwrite or Buywrite. Investors who sell call options against a long position
in the underlying stock give up any appreciation in the stock price above the strike
price of the call option, and they remain exposed to the downside of the underlying
stock in return for receipt of the option premium.
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