Interest Rate Swaps Volatility Strategy

The implied volatility for 1-month at-the-money swaption US 10-year Rate exceeded realized volatility 67% of the time. The average difference was 1.6%. However during periods of market turmoil, volatility investments experience heavy losses.

Every month the same amount of capital is invested by selling 1-month 10-year US Swap Rate swaption straddle and delta hedging it until expiration.

Market Risk Indicators are implemented to filter calm market periods where significant risk losses are small and other periods where market risk is high. When the market is nervous implied volatility rates spike up and this the time to take risk off.

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Volatility Risk Premium is the return investor A gets as compensation for insuring investor B for risk of losses during sudden increases in market volatility and extreme market events like financial crisis. Technically, volatility premium is the profit gained from the difference between implied and realized volatility.

Every month the same amount of capital is invested by selling 1-month 10-year US Swap Rate swaption straddle and delta hedging it until expiration. If market risk indicators predict high volatility in the near future and increased market risk, the investment is not executed for the following month.

Market Risk Indicators are implemented to filter calm market periods where significant risk losses are small and other periods where market risk is high. When the market is nervous implied volatility rates spike up and this the time to take risk off.

The Market Risk Indicators and Rules applied to this strategy are:

1. GARCH Model: if the difference between implied volatility and GARCH predicted actual volatility does not exceed a threshold, don’t take the risk of shorting volatility
2. Slope of Volatility curve: 1-month vs 1-year option maturities: Volatility curve ratio is the ratio between at the money volatilities of 1-month and 1-year options for US 10-year swap rates. Only invest in the volatility risk premium (selling straddle in order to receive volatility risk premium) if yesterday’s volatility curve slope is not higher than its own historical average.

Annualized return of the strategy 13.50% with annualized volatility of just 14.50% generating a Sharpe Ratio of 0.95. The strategy’s returns are not correlated with other traditional asset classes like stocks and bonds. The correlation coefficient of returns between strategy and benchmark indices are close to zero.