VARIANCE AND VOLATILITY SWAPS

Traditionally, investors gain exposure to the market’s volatility through standard call and put options, derivatives that also depend on the price level of the underlying asset. By trading derivatives on variance and volatility, investors can take views on the future realized volatility directly. The simplest such instruments are variance and volatility swaps. A volatility swap is a forward contract on future realized price volatility. Similarly, avariance swap is a forward contract on future realized price variance, variance being the square of volatility. In both cases, at inception of the trade, the strike is usually chosen such that the fair value … Continue reading VARIANCE AND VOLATILITY SWAPS

The Rebalancing Premium

The principle behind a traditional 60/40 investment portfolio is balancing two asset classes – large-cap U.S. stocks and U.S. bonds. The rationale is that U.S. stocks and bonds have low performance correlation – historically, bond funds seldom have had negative annual returns, while stock funds lost money in a calendar year nearly 30% of the time. All bond funds, of course, are not created equal in terms of their raw performance or correlation to the stock fund with which they’re teamed up in a 60/40 portfolio. Investors understandably may seek a bond fund with the best performance. But if the … Continue reading The Rebalancing Premium

Calculation of Sharpe Ratio, which method should I use

Recently, I deeply got involved in calculating the Sharpe Ratio for different portfolios, and sometimes the Sharpe Ratio is very high for (unknown) some reason. Then I went through some web page and try to figure out what’s the typical way to calculate the Sharpe ratio. Start from this link: http://quant.stackexchange.com/questions/10390/sharpe-ratio-annualized-monthly-returns-vs-annual-returns-vs-annual-rolling-ret And, clearly, there is more than one way to do it and I would like to quote one of the popular answers, which says: There are sufficiently different ways to calculate the Sharpe ratio that the best advice I can give is to do whatever your boss wants. Also, if … Continue reading Calculation of Sharpe Ratio, which method should I use

Arithmetic vs. Logarithmic Rates of Return

Say you hold a stock as it increases from $100 to $105. Usually, this is reported as a return of 5%. The formula for this return (which we’ll call arithmetic) is as follows: This simple definition of return serves us well for most uses, but there are some quirks that make arithmetic returns difficult to use in some academic and valuation settings. For example, continuously compounded arithmetic returns are not symmetric. If a position appreciates 15% and then depreciates 15%, the total change is -2.25%. To avoid this quirk, practitioners sometimes use log returns, which are defined as follows: The … Continue reading Arithmetic vs. Logarithmic Rates of Return

The futures price is not a price prediction

The price of a commodity futures contract is not the market’s forecast of what the spot price will be in the future. For example, the fact that at the time of writing the price of the December-2016 WTI Crude Oil futures contract is $64.44 does not imply that ‘the market’ expects the price of oil to rise from around $59 (the current spot price) to around $64 by the end of next year. Moreover, the true message of the difference between the futures price and the spot (cash) price can be the opposite of the superficial message, in that the … Continue reading The futures price is not a price prediction

Forward and currency swap

Generally, we have the intuition that forward has worse rate then swap. FX Forwards A forward is a contract that locks in the price at which a counterparty can buy or sell a currency on a future date. The exchange rate is typically today’s rate, adjusted for the interest rate differential in the two currencies. If the interest rate in the local currency is higher than that of the USD (or whatever the reference currency is), the FX forward will include a devaluation expectation. A forward can be used to hedge the foreign exchange exposure of a loan or an … Continue reading Forward and currency swap