Is Volatility an Asset Class?

[Maverick74]

Interesting question. But aren't there many assets that are bounded? Theoretically, a simple treasury bond is bound by 0, since market participants would just hold physical cash instead of accepting negative rates. Obviously, we are in the midst of a lot of central bank experimenting with NIRP and it is now readily apparent that empirically, rates can breach the zero lower bound, although I doubt by too much. I would say that a lower bound still exists, just somewhat lower than thought. Moreover, aren't T-bills considered assets? They may have short lives, but they are still considered to be assets. Investors just roll them to produce a virtually continuous investment in the T-bill asset class. So couldn't the same argument be applied to a long or short vol portfolio?

So there is a breakdown here in terminology. Assets that have value beyond 12 months are referred to as capital assets. Assets that terminate in value in under 12 months are referred to as money market instruments. So Bonds are typically referred to as capital assets and t-bill are money market instruments.

Bonds have no where near zero rates, those are only money market instruments. Also bonds produce both a cash and a capital component to them. I like to think of an asset as something that one can sit down value the asset from a known set of cash flows. Which is why I don't like to think of Gold as an asset for example. But a variance swap, what is the known cash flow? There really is no way to value that asset long term. It has to be actively traded. We can value securities, bonds, annuities, mortgages all from their future cash flows. That is the standard CAPM model. But how would you value long term the future cash flows of a variance swap?

 

[El OchoCinco]

Somebody please explain why the discussion of whether volatility is an asset class is going to help you make more money in the market? Lot of these type of ET pissing matches but in the end you all sound like kids arguing over Batman v. Spiderman...

 

[Maverick74]

Somebody please explain why the discussion of whether volatility is an asset class is going to help you make more money in the market? Lot of these type of ET pissing matches but in the end you all sound like kids arguing over Batman v. Spiderman...

Hey Coach, are there threads on ET that help you make more money in the market? Holy smokes Batman, show me! Good to see you again OC.

 

[Amalgam]

That is not correct. There is no "jump" in value. The "discount" rate, which is what the world uses to discount future cash flows of any asset has a risk premium embedded in that rate. That rate changes on a daily basis. The discount rate I assign to XYZ today will be different then the one I assign tomorrow given new information. This is finance 101. You might want to google discount rates and NPV before you hop back on the train here.

So a more favorable discount rate doesn't increase NPV? News to me. Thanks oh-wise-one.

 

[El OchoCinco]

Hey Coach, are there threads on ET that help you make more money in the market? Holy smokes Batman, show me! Good to see you again OC.

Ha ha....i am sure your thread group loves your Fisher ACD thread for honest trade discussions of that method but the rest.....pure fun and downtime distraction

 

[Maverick74]

So a more favorable discount rate doesn't increase NPV? News to me. Thanks oh-wise-one.

No raising the discount rate lowers the NPV.

 

[Amalgam]

No raising the discount rate lowers the NPV.

I never said raise. I said more favorable. Which assuming you are long the asset would mean a lower one.

But how would you value long term the future cash flows of a variance swap?

Which are you asking here? That the cash flows are uncertain or that they're un-valuable?

 

[Maverick74]

I never said raise. I said more favorable. Which assuming you are long the asset would mean a lower one.



Which are you asking here? That the cash flows are uncertain or that they're un-valuable?

Ahh, playing the ambiguous card now. Look, your statement was that there is some kind of "jump" in value when the discount rate changes like a one off event. I explained to you that the risk in the market is a continuous factor. It get's discounted daily. Therefore, a "volatility" factor is embedded in equities via the discount rate. So there are two questions here.

One, does this asset produce any cash flows? If no, then how we do value it?

If yes, then we can assign probabilities to those expected cash cash flows and get their present value and arrive at the ENPV or the expected net present value. If there is no way to value these cash flows, then even if we know the asset has cash flows, there is no way to value this product as an asset. It does not mean it does not have some qualities that an asset otherwise would have, for example art. But if we can't value the asset or if the asset has to be continually turned over (active trading) then perhaps it should be called a speculative instrument.

 

[Amalgam]

Ahh, playing the ambiguous card now. Look, your statement was that there is some kind of "jump" in value when the discount rate changes like a one off event. I explained to you that the risk in the market is a continuous factor. It get's discounted daily. Therefore, a "volatility" factor is embedded in equities via the discount rate. So there are two questions here.

One, does this asset produce any cash flows? If no, then how we do value it?

If yes, then we can assign probabilities to those expected cash cash flows and get their present value and arrive at the ENPV or the expected net present value. If there is no way to value these cash flows, then even if we know the asset has cash flows, there is no way to value this product as an asset. It does not mean it does not have some qualities that an asset otherwise would have, for example art. But if we can't value the asset or if the asset has to be continually turned over (active trading) then perhaps it should be called a speculative instrument.

I'm not being purposely ambiguous. I'm just allowing for my argument to be used both on the long and short side despite this thread being about short vol. My discount rate "jump" is in reference to the difference in the discount rate at time of purchase and time of sale. It changes continuously but you realize discretely.

As regards valuing cash flows I agree. However some assets that don't produce cash flows directly can produce them indirectly, I'll call them "synthetic cash flows"(I don't know if there's an actual term for this just using it here.) Say you own a patent that allows you monopoly rights to sell a product above what an otherwise competitive market would allow. Those excess profits would represent a "synthetic cash flow" paid by the patent. Maybe owning a variance swap allows you to take more risk elsewhere and earn higher cash flows?

 

[Maverick74]

I'm not being purposely ambiguous. I'm just allowing for my argument to be used both on the long and short side despite this thread being about short vol. My discount rate "jump" is in reference to the difference in the discount rate at time of purchase and time of sale. It changes continuously but you realize discretely.

As regards valuing cash flows I agree. However some assets that don't produce cash flows directly can produce them indirectly, I'll call them "synthetic cash flows"(I don't know if there's an actual term for this just using it here.) Say you own a patent that allows you monopoly rights to sell a product above what an otherwise competitive market would allow. Those excess profits would represent a "synthetic cash flow" paid by the patent. Maybe owning a variance swap allows you to take more risk elsewhere and earn higher cash flows?

That term you are referring to in regards to synthetic cash has a name, it's called "economic rent" and that applies directly to patents. Economic rent is different then cash flows. You can value that more perhaps as an option vs a cash flow.

The issue I have with the variance swap is to realize it's value, you have to really value the "trader", not the swap because the swap cannot be valued long term, but the value of the trader trading it can. Because each trader has a different value associated with them, we have to value each trader individually. You might make a killing trading these and therefore we place a high value on you, not the swap. I might get killed trading them. I have a low value. We are both trading the same instrument but producing radically different cash flows. This is why I have an issue valuing the swap or any product that has to be constantly turned over to generate value. You cannot simply invest in a var swap. You have to buy low, sell high, sell high, buy low....so we have a huge timing issue here that is going to be very difficult to value. But we can value the skill of the trader trading them.