Risk Latte - 1995-1996: Vanna, Vomma and the Dollar Mark Trades-Part I

1995-1996: Vanna, Vomma and the Dollar Mark Trades-Part I

Rahul Bhattacharya
May 20, 2006

These days with the global markets going for the Mount Everest, some very sophisticated, and some very intelligent traders have been biting their nails off. Though phrases like "knock-outs", "vega" and "vol are very common in the parlance in the dily life of derivatives traders of late we have heard quite a few times the phrases, "reverse knock-out", "vanna" and "vomma", especially with respect to the commodities and the Dollar-Yen. A trader in a hedge fund in Asia pointed us to the events in the currency markets almost a decade ago (and we looked up the reference on the internet). Here is a two part article on that.

1995 was the year of the Vanna, which is mathematically expressed as , and which in English means how the vega of an option (vega is the volatility sensitivity of an option) varies with the underlying spot. And in 1996 Vomma became infamous. Vomma is mathematically expressed as and which captures the movement of the volatility sensitivity of an option (vega) with the underlying volatility itself. Both these measures are complex second order effects (something like the convexity or gamma) and even today very few traders in the banks have a handle on them. But in 1995-1996 they became a major headache and most of the exotic traders, even some of the very good ones, could not understand and get around these two measure. for many currency traders and USD-DEM (Dollar-Mark) was the main culprit.

On March 8, 1995 the Dollar-Mark opened at 1.3700 and within moments experienced a jump and the rate dropped to 1.3450 (i.e. Dollar weakened and the Mark strengthened). This prompted a large number of reverse knock-out options to get triggered. And this in turn meant that the traders who were on the same side of the market, i.e. short Dollar and long Mark, no longer had to pay out on the original trades. But this also left them massively short options that they had been selling as a hedge against their original investment. All of them immediately rushed to buy back these options and thereby driving up the volatility of Dollar-Mark to almost 15%. Their action of buying back the options increased the costs associated with Vanna and Vomma and these costs were not factored into the pricing model for the reverse knock-outs when the trades were initiated. And this caused losses on a mark-to-market basis. Vanna and Vomma were increasing becasue Vega of the options was increasing both with increasing volatility of Dollar-Mark as well as the underlying spot (long Mark short Dollar).

If these traders, many of whom were market makers, had priced their trades realistically when initiating these trades by calculating the costs associated with the hedges and costs associated with unwinding them by taking into account the costs of Vanna and Vomma they would have been spared the losses, at least the greater part of it.

To be Continued............

Source: Conversation with Traders and the article by Andrew Webb in Derivatives Strategy, November 1999. (www.Derivativesstrategy.com)

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