Buying and Selling Volatility: Volatility Swaps and Unlawful Market Activity

Abstract

Institutional investors and traders are beginning to view volatility as a distinct asset class, capable of being invested in and traded in the same manner as other asset classes. This article provides an overview of the use of options to trade volatility (on their own, or embedded in securities such as reverse convertibles) and the new derivative instruments for the trading of volatility (volatility swaps and variance swaps).

Volatility derivatives reveal significant anomalies in the regulation of financial markets transactions in Australia. The Australian Corporations Law distinguishes between "securities" and "futures contracts". Volatility derivatives are clearly not securities and, depending on the manner in which they have been structured, may also fall outside the definition of futures contracts.

Despite this, where a volatility derivative relates to the price volatility of a security (including shares, bonds and equity options), a dealing in that security by one of the transaction parties will also subject its counterparty to the provisions of the Corporations Law regulating securities. This article examines the application of the Corporations Law prohibitions against unlawful market activity in securities to volatility swaps.

Note: This is a description of the paper and not the actual abstract.

Keywords: Volatility, volatility swaps, unlawful market activity, false trading, market manipulation

JEL Classification: G24, G28, K22