Can Variable Annuity Hedging Explain the Excess Implied Volatility Puzzle?

Description

Excess implied volatility is a key stylized fact in derivative markets. Excess volatility is the fact that the relationship between short-dated and long-dated option implied volatility deviates strongly from an entire class of rational models – long-dated volatility moves “too much” relative to predictions from models given movements short-dated volatility. The leading explanation for this stylized fact is investor behavioral mistakes. I describe how a large and often neglected market participant can drive these effects. Variable Annuity guarantees embedded in insurance company liabilities drive a very particular set of exposures for derivatives dealers. Ultimately, dealers are forced to purchase long-dated volatility after an increase in short-dated volatility, and they are forced to sell long-dated volatility after a decrease in short-dated volatility. This mechanism can potentially explain the excess volatility puzzle and makes unique predictions - absent in alternative explanations - about the products and times in which the excess volatility effect will be stronger.