Why Netted Spread Positions Can Be More Volatile

Summary

The document explains how a netted position can show a larger percentage change than its gross component exposures. It uses a crude-oil curve spread: one maturity is short and another is long, leaving a small net exposure compared with the combined gross exposure. When both oil prices rise by different amounts, the gross exposure changes modestly while the small net value changes much more as a percentage.

The example illustrates a denominator effect: offsetting legs make the net position relatively small, so modest changes in the legs can produce large percentage swings in net exposure. This does not mean that netting necessarily increases the absolute dollar risk or volatility of the underlying legs. The explanation is specific to a spread with offsetting exposures and changing relative prices; broader risk comparisons require attention to the position definition and chosen volatility measure.

Key ideas

• Offsetting long and short legs can make net exposure small relative to gross exposure.
• A small net-value denominator can cause a larger percentage change than the corresponding change in gross exposure.
• The example demonstrates relative percentage movement, not necessarily greater absolute dollar risk.
• Volatility comparisons depend on how gross and net positions are defined and measured.

Tags

# Why are netted positions more volatile?


# Why are netted positions more volatile?












According to John Gregory, "netted positions are inherently more volatile than their underlying gross positions". Given the context, I think he's talking about close-out netting and not payment netting.

I can't figure out why the netted position would be more (or for that matter less) volatile.

## Answer by realizedvariance (score 3, accepted)

https://quant.stackexchange.com/a/20894

I think the easiest way to explain this is with an example of a spread trade. Consider a curve trade on WTI crude oil such that you're short 1y oil and long 2y oil. 1y oil is at \$50 and 2y oil is at \$54. You have one contract on each leg for a gross exposure of \$104k and net exposure of \$4k. If 1y oil moves up \$5 to \$55 and 2y oil moves up \$6 to \$60, your gross exposure is now $105k and your net exposure is now \$5k. Your gross exposure moved up ~1% while your net exposure moved up 25%. This is a crude (pun intended!) example of how netted positions can be more volatile than gross positions.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.