Barclays' notes on Short-Term VIX, Mid-Term VIX offer bet on term structure of volatility

By Emma Trincal

New York, Oct. 12 - Barclays Bank plc's $6 million of 0% notes due Oct. 11, 2013 based on the S&P 500 VIX Short-Term Futures Index Excess Return and the S&P 500 VIX Mid-Term Futures Index Excess Return enable investors to bet on the term structure of volatility while expressing a view on the market, said Michael Iver, a former structurer at JPMorgan.

The notes are linked to a portfolio that has a long position of 70% in the mid-term index and a short position of 30% in the short-term index, according to a 424B2 filing with the Securities and Exchange Commission.

The Chicago Board Options Exchange Volatility index, also known as the VIX index, is a measure of forward volatility of the S&P 500 index.

Overall, the notes give investors the opportunity to hedge an equity portfolio and to take directional bets on the direction of the market based on short-term and mid-term volatility moves, Iver said.

The payout at maturity will be par plus any gain in the portfolio less an investor fee, which will be 1.15% per year. Investors will be exposed to any losses in the portfolio.

The notes are putable at any time, and they will be called if the net value of the portfolio falls to 30% or less of its initial level.

Sophisticated note

"This is a very sophisticated note," said Iver. "It allows investors to express their view on the term structure of volatility."

The term structure of volatility refers to how implied volatility will vary based on the term of an option.

The VIX index is based on long S&P 500 futures positions that are rolled continuously throughout the period between futures expiration dates.

The Short-Term VIX index measures the return from a rolling long position in the first- and second-month VIX futures contracts, an the Mid-Term VIX index measures the return from a rolling long position in the fourth-, fifth-, sixth- and seventh-month VIX futures contracts.

"Since investors anticipate the short end to decline and the longer end to rise, they are betting that the volatility curve will steepen," said Iver.

"In other words, they see the market getting quieter short term, but they anticipate market losses at a later stage."

That's because volatility is "negatively correlated" to the equity market performance, he explained.

As a result, "being long volatility" means the anticipation of a market decline. And symmetrically, "shorting volatility" is to anticipate a more stable or bullish market.

Effective exposure

The underlying bet of the investor, or his "effective exposure" to one of the two VIX indexes, may be more difficult to interpret, noted Iver, who looked at the underlying portfolio with its 30% short and 70% long exposure.

It is not obvious to conclude that investors are either bullish or bearish on the market given that the underlying portfolio, instead of being equally weighted, has a 70-to-30 ratio with 70% representing the long exposure and 30% the short position, said Iver.

"It's interesting to see that they have a lower nominal exposure to the short-term relative to the long-tern. I think it's because the short-term maturities of the VIX index move around a lot more than the mid-term," Iver said.

In order for an investor to gauge what his "effective exposure" to the short-term index is relative to the mid-term index, a comparison needs to be made "between the short-term moves of the VIX index and the 70-30 ratio," he explained.

"If you think the short-term index will move by more than this ratio, you end up net short volatility, in other words, you're bullish on the market," he said.

"If you think that short-term volatility will move by less than this ratio, then you're net long volatility and therefore bearish.

"This note is a market hedge but not a perfect hedge. It's a secondary hedge. Whether or not the note is appropriate for someone who is bullish or bearish on the market is a direct result of this ratio."

Iver said that he "liked" the product because it gives investors a way to play not just on the inverse correlation between volatility and market performance but also on the volatility move differences between the short term and the medium term.

'Tough call'

Frederick Wright, partner and chief investment officer at Smith & Howard Wealth Management, said that he understood why an investor would change his outlook on volatility as time elapses and why a trade could be based on that.

"You could certainly be bullish for the next two or three months and bearish after that," Wright said.

"But we haven't done volatility trades, and I don't think we will. The idea that you're going to know when the market is going to be more volatile, I just think it's a tough call. So many things can happen on any particular day or week. It's a tough way to make an investment," he said.

The fees are 0.15%.

Barclays Capital Inc. is the agent.

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