By Peter Huber, Investment Writer & Navdeep Sahote, Senior Technical Account Manager
2022 has witnessed an abrupt shift in the macroeconomic environment, with inflation soaring and interest rates across the yield curve rising sharply in response. This change in the prevailing regime has seen equity and bond prices – generally regarded as uncorrelated – fall in tandem. Yet, investment managers seeking to maintain diversified portfolios require truly uncorrelated investment strategies. Trading swaptions offers such an approach.
Swaptions allow investors to limit their existing fixed income exposure by hedging against interest rate movements. Additionally, they can be used to form stand-alone alpha strategies. In this blog we consider the use of a volatility carry strategy using the SigTech platform and its rich pool of swaption data (provided by IHS Markit) and utilizing its extensive range of fully customizable building blocks which greatly accelerate the research process. The economic rationale for such a strategy emerges out of the deflationary impact that rising interest rates have on the swap market. In a volatile market environment, where rates are rising sharply and greater than expected – as we have seen throughout 2022 – opportunities emerge to garner healthy profits from trading swaptions.
The strategy relies on identifying discrepancies between implied and realized volatility. This is achieved by matching the forward tenor of the swap with the expiry date of the swaption. Taking the largest discrepancies between the two types of volatility, we calculate a ratio which we use to generate a trading signal. These ratios are then used to create a straddle; selling the highest and buying the lowest. A day before expiry, we recalculate the volatility ratios and roll out of those swaptions whose ratios are no longer at the extreme ends of our signal dataframe. The newly held swaptions may or may not have the same tenor as the ones previously held. The strategy is denominated in USD and rolls at the end of each month.
Evident from the return series above, the profitability of the strategy increases in line with market volatility. Annualized excess returns are 6.64%.
In order to hedge against the directional risk of the underlying swap, we can run a delta hedging strategy over the same time period, producing an annual excess return of 7.48%.
Applying the same strategy to swaptions denominated in other currencies produces similar results. The graph below describes a volatility carry strategy for GBP, with an annualized excess return of 5.57%.
The corresponding delta hedge on the underlying swaps yields an annualized excess return of 4.65%.
SigTech’s quant technologies platform accelerates and streamlines the research and construction of global macro investment strategies. A volatility carry strategy, trading swaptions and hedging interest rate risk is only one of the strategies that can be made instantly accessible using the 100+ building blocks available on the platform. Supporting this is a comprehensive array of financial instruments across all liquid asset classes and an extensive range of financial and alternative datasets; clean, validated and operationally-ready. Our open source code is fully customizable to the individual specifications of the user, freeing investors to focus on research and alpha generation.
(1). Figures generated on the SigTech platform on November 14th, 2022. Data provided by ICE.
This document is not, and should not be construed as financial advice or an invitation to purchase financial products. It is provided for information purposes only and is subject to the terms and conditions of our disclaimer which can be accessed at: https://www.sigtech.com/legal/general-disclaimer
This content is not, and should not be construed as financial advice or an invitation to purchase financial products. It is provided for information purposes only and is subject to the terms and conditions of our disclaimer which can be accessed here.