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Smooth out ride on the rollercoaster

Volatility is likely to be the keyword as unpredictable markets continue to grab headlines.

Only a year ago, equity markets were trundling nicely upward but since the summer we have been awoken from that sleepwalk and put on something more like a rollercoaster.

Most people have a general idea of what volatility means – it is a measure of the dips and rises in that rollercoaster – but do your clients know what they can do to protect their investments in volatile market conditions or how they can harness volatility to their advantage? We can use sophisticated financial tools to help clients with their investments this yearVolatility is really just a measure of the risk involved in investing in an asset and is experienced across the financial world. For structured products, a change in volatility is the key driver of price, so some traders only quote in terms of volatility.

Higher volatility means that an asset’s value can potentially be spread out over a wider range of potential outcomes. This means that the price of the asset can change dramatically over a short period of time in a non-directional manner, so there is as much likelihood of an up as a down. Lower volatility means that the asset’s value does not fluctuate dramatically but changes at a steady, almost predictable pace over a period of time.

Is volatility a good or bad thing for your clients? Most investors see volatility as not only dangerous but something to be avoided at all costs. However, as you probably tell your clients on a daily basis, you do not get a good return without taking some added risk. If there was no volatility, there would not be the potential for high profits, which is one of the main attractions of investing in the stockmarket.

New investment areas such as the Bric countries (Brazil, Russia, India and China) demonstrate high volatility but there is no doubting the rewards that investors have enjoyed, at least until the latter part of 2007. By contrast, the returns from more mature areas have been pedestrian. Now the landscape has changed and in some ways we are back to 2002 and the end of the dotcom boom. All sectors are volatile.

To demonstrate how this translates into the design of a protected investment, barely a year ago, the norm for a five-year guaranteed equity bond would have been to capture 120 per cent of the rise in the FTSE 100 index. Today, it will be less than 100 per cent.

The investor is not paying any less for their investment, it is just that the price of the call option – which delivers the equity return – has increased because of the pick-up in volatility. Essentially, it is just that the range of potential outcomes is wider, more uncertain and therefore the cost of the underlying option is more.

The price of options is affected by the change in the level of implied volatility used. Implied volatility is merely an estimate, albeit a very calculated one, of how traders think the underlying option will move.

In a crude approximation, think of this as a weatherman trying to forecast the next storm. Having learned from the troubles of Michael Fish, they are probably more likely to overestimate the chances of a storm than underestimate it. It is better to be prepared.

Financial markets tend to overestimate the level of volatility, so there is normally a difference between implied volatility and realised volatility, which is the volatility actually experienced in the market.

As a result, trading on realised volatility can bring about a real investment benefit. This means that you are not paying up front for a level of volatility priced into the structure but are taking the chance of riding out the ups and downs during the term of the trade in the hope that the actual volatility experienced is less than the implied volatility priced into a normal option and so your ultimate gains could be more.

The rationale behind this is that falls in volatility levels are most commonly associated with a rising and more predictable market and so participation increases during this time. Higher volatility levels are more commonly associated with falling or uncertain market conditions and so deleveraging is sensible during these times.

This type of product could be argued to be a smoothing vehicle as it tries to iron out some of the highs and lows in asset classes by adjusting exposure in line with volatility.

Derisking in periods of high volatility and gearing up in more benign times is intuitively the right thing to do. Singling out volatility as a control is a relatively new concept for structured products but there are other smoothing structures that are popular in the UK retail market. Continuous proportion portfolio insurance structures work in a similar manner but adjust exposure according to changes in price instead of volatility.

In an uncertain market environment which may continue for a while, these types of product, which ess-entially aim to deliver more stable returns, can provide a benefit for your clients.

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