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“The difference is that that is an unrealized loss and a lot of that would have come back in the recent market rally,” he said. “The loss on this volatility strategy is money gone that is never coming back. It is a permanent loss of capital.”

Keohane said he suspects AIMCo had a short position in volatility taken via swaps.

If this were the case, the pension fund would collect each day that volatility stayed below the level at which the transaction was made and pay out when volatility moved higher.

“The calculation is quite complicated, but an important aspect is that it is non linear — in other words as volatility goes up the loss per point increases,” Keohane said.

“Prior to the recent market decline volatility was trading around 10, and in the crisis it spiked to almost 90 which is the second-highest reading in history. It is still in the mid 40s so you will still be paying away significant amounts every day unless you close out the strategy.”

Keohane said the “opened-ended” risk of such a strategy has been described to him as “picking up dimes in front of a steamroller — most of the time you get your dime but occasionally you get run over.”

The slightly higher levels of volatility reached in 2008 should have been used as a “stress test,” Keohane said, but he added that what transpired was probably well outside risk models that would have been used as worst-case scenarios.

“The event that just occurred is the absolute worst outcome for a strategy like this,” he said. “The issue is that the loss is very high relative to what they could have ever made on the strategy.”