The Montréal Exchange’s Quarterly Derivatives Newsletter 2011, volume 2 CADerivatives CADerivatives BAX OBX ONX CGZ CGF CGB OGB LGB SCF SXF SXM SXA SXB SXH SXY BAX OBX ONX CGZ CGF CGB OGB LGB SCF SXF SXM SXA SXB SXH SXY EQUITY OPTIONS CURRENCY OPTIONS INDEX OPTIONS ETF OPTIONS EQUITY OPTIONS CURRENCY OPTIONS INDEX OPTIONS ETF OPTIONS CADérivés CADérivés BAX OBX ONX CGZ CGF CGB OGB LGB SCF SXF SXM SXA SXB SXH SXY BAX OBX ONX CGZ CGF CGB OGB LGB SCF SXF SXM SXA SXB SXH SXY OPTIONS SUR ACTIONS OPTIONS SUR DEVISES OPTIONS SUR INDICES OPTIONS SUR FNB OPTIONS SUR ACTIONS OPTIONS SUR DEVISES OPTIONS SUR INDICES OPTIONS SUR FNB Table of contents Season’s Greetings ....................... 2 CADC 2011: A Resounding Success .................. 4 Volatility Opportunities through OBX Options on BAX Futures ...... 6 The Montréal Exchange to Open its Doors in New York City ........... 14 First Quarter 2012 Initiatives .......... 16 Trading Data ................................. 20 Upcoming Events ......................... 22 2 3 Beyond this, we are working on building tailored solutions for the Season’s Greetings upcoming reforms to the OTC derivatives space and also to improve market efficiencies further to the 2008 financial crisis. Extensive work has gone into the CDCC clearing solution for the repo market, which On behalf of everyone at MX, it gives me great pleasure to wish you we expect to come online early in 2012. and your family all the best for this upcoming holiday season, and for the new year to come. In collaboration with Finance Montréal, we are also taking part in high value-added activities for the benefit of Quebec’s entire financial With your continued loyalty and support MX has enjoyed yet another sector. banner year, expanding our international presence through the European office we opened in London, launching new products and Thank you for helping to make this our best year to date. As we making great technological strides. We also set numerous trading embark on a new year, be on the lookout for still further development volume records, including the world’s biggest rise in volume for the and expansion as we strive to show the world why they should be first half of the year with our Options on Three-Month Canadian trading Canada. Bankers’ Acceptance Futures. This summer we implemented the groundbreaking Yield Curve Alain Miquelon Project, a five-year initiative dedicated to developing a full sovereign President and Chief Executive Officer, Montréal Exchange yield curve. Several market makers were contracted to ensure ample Head of Derivatives Markets, TMX Group liquidity for all market participants. We also amended our option fee schedule, introducing rebates on retail trades as an incentive for brokers to develop the market and implementing a fee cap at 10,000 contracts to encourage institutional clients to execute larger size trades at greater cost efficiency. CADerivatives 4 5 CADC 2011: A Resounding Success Held at Fairmont Le Château Frontenac in Québec City on Video recordings of all CADC 2011 presentations will be made available November 29 and 30, the Montréal Exchange’s 12th annual Canadian at www.m-x.tv during the month of December. Annual Derivatives Conference welcomed a record 225 participants, with a vast array of specialties in the derivatives industry. Tickets sold out well in advance of this year’s event, so be on the lookout for announcements on the next edition, CADC 2012. We look “The Montréal Exchange is pleased to be able to once again provide forward to seeing you all there. a forum where buy-side and sell-side professionals, as well as technology vendors, gather to discuss global and Canadian industry trends,” said Alain Miquelon, President and Chief Executive Officer, Montréal Exchange. Expert panellists were on hand to provide timely insights into such topics as regulatory reforms in Canada, the US and Europe, and developments in the clearing space with a highlight on clearing OTC derivatives. CADerivatives 6 7 Generally, volatility works its way through every strategy. Implied Volatility Opportunities volatility and historical volatility can gyrate significantly and quickly, moving above or below an average or “normal” level, and then eventually revert to the mean. through OBX Options In Canada, we have seen a large upswing in the implied volatility on BAX Futures of OBX options on BAX futures contracts (a key indicator of market expectations for the future direction of the Bank of Canada’s overnight rate target). Implied volatility has been at the upper end of the Given the large and frequent shifts in volatility experienced in historical range since 2007. such periods as 2008, 2009, and more recently 2011, interest rate instruments which manage the volatility risk inherent in interest rate futures have become more relevant. In contrast to interest rate futures contracts, interest rate option contracts provide greater flexibility since they can be used to manage volatility risk as well as interest rate risk. When implied volatility (as measured by the price of OBX options) is above its historical norm and expected to fall, a short straddle or short volatility trade comes in useful. This strategy consists of the simultaneous sale of a call option and a put option with the same strike price (generally an at-the-money strike) and expiry month. A short straddle is effective when participants expect the Bank of Canada to keep its benchmark interest rate on hold for an extended period, and when implied volatility is expected to fall in the future. It is considered a “non-directional” strategy because the short straddle profits when the price of underlying BAX futures only moves modestly before expiration of the straddle. The short straddle may also be classified as a credit spread because the sale of a straddle results in a credit of the premiums collected from the put and call options. CADerivatives 8 9 Going into the second quarter of 2011, participants factored several Vega, just like the other “Greeks”, tells us about risk from a volatility Bank of Canada rate increases (against a backdrop of robust economic perspective. Traders refer to option positions as either “long” or data in Canada) into the prices of options on futures (OBX) and futures “short” volatility, though of course it is possible to be “flat” volatility (BAX) contracts, with a quite steep BAX forward curve relative to the as well. The terms long and short here refer to the same relationship forward curve of other international short-term interest rate futures pattern as when speaking of being long or short an interest rate contracts where the prospects for economic growth were much softer. futures contract, or an option contract. That is, if volatility rises, a In Canada, market uncertainty was due to timing concerns as in when position that is short volatility will experience losses; and if volatility exactly the Bank of Canada would raise rates. falls, that same position will experience immediate unrealized gains. Likewise, with a position that is long volatility, when implied volatility This all changed abruptly during spring and summer when many rises, there will be unrealized gains; while if volatility falls, losses will participants had to re-price their interest rate expectations as a result result. of unexpectedly dovish comments by the Bank of Canada, along with the impact on future economic growth prospects due to the Hence, short call and short put traders benefit from an expected worsening sovereign debt crisis in Europe. The result was a huge shift decline in implied volatility. This is demonstrated by the following to lower and flatten the BAX curve, with a large re-pricing on deferred short volatility trade with OBX options. BAX futures whose prices had previously factored in several rate increases in 2011 and 2012. The short straddle or short volatility trade As a result, participants have recognized the relevance of the OBX This trade consists of the sale of a call option and a put option with contract in terms of managing volatility risk and interest rate risk, the same strike price (at-the-money) and the same expiry month. such as we have seen this year. Initial data More often, participants manage volatility risk, or “vega”, at the June 2012 BAX futures price: 98.93 (implied rate of 1.07%) portfolio level where the overall vega position is adjusted using straddles. Participants buy and sell straddles - or similar options June 2012 OBX options: strategies - to adjust a portfolio’s exposure to interest rate volatility, Strike Price June 2012 June 2012 without changing exposure to other market risks. (at-the-money) Call Options Price Put Options Price (in basis points) (in basis points) 99.00 19.5 26.0 (implied volatility of 76%) (implied volatility of 74%) CADerivatives 10 11 Based on a notional of C$50 million (or 50 option contracts), the A note on volatility: strategy consists of selling 50 June calls at a strike of 99.00 and selling If implied volatility of the option position (as measured by vega) 50 June puts at a strike of 99.00. moves higher by one percent, the short straddle position would be expected to lose $726. Vega is defined as the expected rate of change Revenue collected from the strategy: in an option’s value for a one-unit change in implied volatility. • Sale of 50 $99-strike June call options for a premium of 19.5 basis points: Multiplier of $25 per basis point per contract × 19.5 basis points × 50 contracts = $24,375.00 • Sale of 50 $99-strike June put options for a premium of 26.0 basis points: Multiplier of $25 per basis point per contract × 26.0 basis points × 50 contracts = $32,500.00 • At the initiation of the trade, the investor has a credit of $56,875.