Volatility as a separate asset class

The new products are futures contracts on the 30-day implied volatility levels of options on the Dow Jones EURO STOXX 50®("VSTOXX®"), DAX®("VDAX-NEW®"), and SMI®("VSMI®") benchmark indexes.

The products can be used to trade pure volatility. Investors are thus able to speculate on changes in volatility, or to hedge their volatility exposure of their portfolio. Using spreads between volatility indexes, they are also able to capitalize on relative shifts in volatility levels. Market participants are thus able to hedge against price fluctuations in European equity markets using a range of volatility futures.

The contracts are particularly important in providing a trading medium for future expected changes in the volatility of stock indexes. To illustrate this point, let us assume an investor expects a major interest rate change, or a large jump in oil prices at some future date, and thus expects volatility levels to rise. With the new futures the investor would buy contracts, as a bet on a sudden rise in implied volatility.

The Fundamentals
The indexes represent an average implied volatility level of the underlying index options. The design follows closely procedures used to evaluate OTC variance swaps, which represent the OTC benchmark in this market segment. Prices for at-the-money and out-of-the-money options are aggregated to yield the average implied volatility levels for every index option expiration out to two years, which are disseminated as individual sub-indexes. The result is the implied volatility term structure, which is in turn used to determine a 30-day rolling volatility index.

The volatility indexes underlying the new futures were launched in April 2005 by Stoxx Limited (VSTOXX®), SWX Swiss Exchange (VSMI®) and Deutsche Börse (VDAX-NEW®), respectively.

Contract Design
The contract value is EUR 1,000/CHF 1,000 per volatility index point. Current volatility levels are at historical lows around ten percent, but the new futures are designed to allow trading or hedging instruments that deal with sudden, sharp movements.

Historical performance studies conducted by Eurex show that the STOXX® and DAX® indexes generally move in step with each other whereas the SMI® volatility quotes lower. Such similarities and variances create additional spread trading opportunities. Given the mean-reverting properties of volatility (where peaks and troughs generally revert to a long-term average) opportunities arise particularly after a volatility event, and where significant fluctuations are anticipated.

Designated Market-Making
The new volatility futures are supported by a Designated Market-Making program. Designated Market Makers will quote in all contract months, during at least 85 percent of the trading period, with a minimum size of ten contracts each on the bid and the ask side. Designated Market Makers thus provide investors with liquidity at all times and with sufficient size.

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