A Guide to South African Volatility: Understanding, Modelling, Investing & Hedging

Peregrine Securities, 2014

33 Pages Posted: 22 Apr 2016 Last revised: 28 Apr 2016

See all articles by Emlyn James Flint

Emlyn James Flint

Legae Peresec; Department of Actuarial Science, University of Cape Town

Florence Chikurunhe

Peregrine Securities

Anthony Seymour

University of Cape Town (UCT)

Date Written: October 15, 2014

Abstract

In this report we study South African implied volatility from three different perspectives. Firstly, we conduct an analysis of the historical Top40 Index implied volatility surface dynamics. In particular, we consider the regime-dependence of atm volatility and skew levels and how this dependence changes across term. We also test the square-root of time trader's heuristic commonly used to describe term structure and skew decay, and go on to propose a more general version of the same as a simple but robust volatility model. Secondly, we show how the expected return of any option trade can be decomposed into two main exposures, namely to the equity risk premium and volatility risk premium, and a latent equity timing exposure. Thirdly, we show how to trade and hedge out volatility exposure. Our proposed solution is to use exchange-traded variance futures. We test two potential hedge candidates in terms of replication precision, margin requirements and transaction costs. From this analysis, we conclude that a long-only variance futures strategy rolled quarterly or biannually provides a reasonable and tradable means of hedging implied volatility exposure.

Keywords: implied volatility modelling, volatility dynamics, option return decomposition, variance swap pricing, volatility trading

JEL Classification: C22, C21, C4, C5, C61, G13

Suggested Citation

Flint, Emlyn James and Chikurunhe, Florence and Seymour, Anthony, A Guide to South African Volatility: Understanding, Modelling, Investing & Hedging (October 15, 2014). Peregrine Securities, 2014. Available at SSRN: https://ssrn.com/abstract=2767432 or http://dx.doi.org/10.2139/ssrn.2767432

Emlyn James Flint (Contact Author)

Legae Peresec ( email )

15 Cavendish Street
Claremont
Cape Town, Western Cape 7700
South Africa
27117227556 (Phone)

HOME PAGE: http://www.legaeperesec.co.za

Department of Actuarial Science, University of Cape Town ( email )

Actuarial Science Section, University of Cape Town
Private Bag X3, Rondebosch
Cape Town, Western Cape 7701
South Africa
+27 21 650 2475 (Phone)

Florence Chikurunhe

Peregrine Securities ( email )

21 Main Road
Claremont
Cape Town, Western Cape 7700
South Africa
+27117227551 (Phone)

HOME PAGE: http://www.peregrine.co.za

Anthony Seymour

University of Cape Town (UCT) ( email )

Private Bag X3
Rondebosch, Western Cape 7701
South Africa

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