CBOE Risk Management Presentation – Arbitraging Volatility Estimates

The 31st edition of the CBOE Risk Management Conference kicked off today with a very educational session from Bruno Dupire who is the Head of Quantitative Research at Bloomberg. His discussion centered on trading volatility which is a core theme of many presentations that will be given over the next few days here in Carlsbad. The timing of Dupire going first at the conference was perfect as his sessions are always as educational as they are informative.  (The Twitter handle for this conference is #CBOERMC)

The presentation started out discussing historical volatility and High-Low estimators which he notes may not be traded. The focus of the presentation asks and attempts to answer the question, “How correct is the market skew”   Before moving forward Dupire gave a brief primer on Delta hedging and then began to explain that if the fair skew may be computed then several questions related to trading may be answered.

Probably the most interesting of the questions for those of us that focus on SPX and VIX was, “Are the strong index equity skews justified?” He proceeded to demonstrate fair skews for a variety of markets ranging from S&P 500 Index options, to gold, to options on the China 50 ETF which began trading in early February on the Shanghai Stock Exchange. The China 50 ETF is an interesting example since historical price action is used to illustrate the fair skew for a market that did not have options available until very recently.

Dupire’s presentation finished with a discussion of Principal Component Analysis with applications to both the bond and equity markets. He notes that based on the application of PCA and time frames measured that the amount of variance explained may vary greatly. Some might get the illusion of having a handle on the present situation, but if some data from a different regime (different time-frame), the result going forward may be incorrect.

Interesting comparison with S&P 100 3-month At-The-Money implied volatility to returns for July 2014 to February 2015 – similar in nature.  Same comparison 4/11 to 4/12, not so similar.  Thr right screen and analyzing the data quickly the key.

The presentation went long with several more questions on delta hedging and comparing US Treasury Rates pre and post the ’08 financial crisis.  Very in-dapth presentation, well received by the 80 attendees.  No handouts available, you had to be here.   Thank you Bruno Dupire!