Energy Storage Systems and Variability Swaps

II. Flip-flopping on needs, interests, positions

This is Part II on connections between symmetric energy assets and variance swaps. In Part I we recalled the basic principles of classical variance swaps and started adapting ideas to the energy markets.

Energy Storage Systems and Variance Swaps

In the equity markets ‘variance swaps’ are closely linked to well-defined machinery surrounding the concept of volatility. In the energy markets we need to think about volatility more broadly. To allow connections while making the necessary distinctions we started using the term “variability swaps.”

The obvious next question is how to define “variability.” We looked at one obvious candidate definition with respect to the needs of market participants, particularly those with renewable energy asset positions.

What other definitions of variability could we can think of to create interesting swaps?

As a constraint, we should require that positions in variability swaps should express needs and interests of market participants. Consider, for example, how interests and needs led to the development of variance swaps in the capital markets.

Variance swaps took off as a product in the aftermath of the LTCM meltdown in late 1998 when implied stock index volatility levels rose to unprecedented levels. Hedge funds took advantage of this by paying variance in swaps (selling the realized volatility at high implied levels). The key to their willingness to pay on a variance swap rather than sell options was that a variance swap is a pure play on realized volatility—no labor-intensive delta hedging or other path dependency is involved. Dealers were happy to buy vega at these high levels because they were structurally short vega (in the aggregate) through sales of guaranteed equity-linked investments to retail investors and were getting badly hurt by high implied volatility levels.

The Volatility Surface: A Practitioner’s Guide, Jim Gatheral, pp. 137-138.

With a bit of imaginative license, this description could be adapted to the energy context as follows.