The hunt for returns in obscure corners of the market may be contributing to bigger swings in the FTSE 100 as the end of the trading day approaches.
The need to hedge complex derivatives used to make bets on volatility explains the sharp jump in volumes of Footsie futures in the final minutes before the close, according to BNP Paribas.
The move was particularly noticeable on Tuesday, when the Footsie had its biggest fall this year. For most of the day it tracked European indices closely, but — even when adjusted for the weaker euro — plunged particularly fast in the final half an hour, as futures trading surged (see chart).
The blame is being put on a renewed willingness by investors to dabble in volatility trading, buying structured products designed to make a return by exploiting the desire of others to protect themselves against extreme market moves.
Investors in effect are acting as insurers, taking in a regular premium but facing the risk of a big loss when markets wobble. One popular method involves using derivatives called variance swaps. The strategy makes money when realised market volatility is lower than implied volatility — a proxy for the cost of insuring a portfolio against losses.
The banks on the other side of the variance swap have to protect themselves at the end of each day using futures. The more the market has moved the more hedging is needed, and the more hedging, the bigger the impact on the market, an effect last noticeable in 2006.
There is nothing iffy about this. But it highlights investors’ increasing willingness to buy complex structured products, from collateralised default obligations to volatility-linked notes based on “strangles” or variance swaps.
Many are better designed than those that contributed to the 2007-08 crisis. Hopefully investors have a better handle on the risks they are taking this time round.
Still, this is an area that bears watching. As the Footsie trading shows, structured products can have quirky effects on markets. More broadly, it is easy for the steady income on products which look like insurance to blind investors to the scale of risks they are taking — especially when central banks are creating a desperate hunt for yield.
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