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

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