Watch this video to gain insight on how VIX expiration dates are determined and why they vary from month to month. Hosted by Michelle Kaufman.
Equity volatility, as replicated by widely traded ETFs and ETNs linked to the S&P 500® VIX® Futures Index Series, is frequently used to hedge equity portfolios. But is it appropriate for bond portfolios?
The bond market is broad and diverse, ranging from low-risk government bonds to relatively high-risk high-yield corporate bonds and emerging market bonds. As a result, equity volatility relates to each segment of the bond market in the following different ways:
- Treasury and municipal bonds are positively correlated with equity volatility because they often serve as safe-haven choices when equity risk is at heightened levels. Therefore, adding S&P 500 VIX Futures Index Series exposure to a portfolio of treasury and municipal bonds does not provide diversification benefits.
- Investment-grade corporate bonds have a weakly positive correlation with equity volatility futures, while high-yield corporate bonds have a weakly negative correlation. During extreme downturns, equity volatility futures can offer corporate bond portfolios some tail risk hedging benefits, but there are occasions when these benefits may not be realized. Risk-return benefits can also be obtained by adding a dynamic allocation of the S&P 500 VIX Futures Index Series to a corporate bond portfolio.
- The most beneficial application of the S&P 500 VIX Futures Index Series is in emerging market bond portfolios. Adding the S&P 500 VIX Futures Index Series generally provides a clear tail risk hedging benefit. Over the period of study, equity volatility futures provided downside protection on all but four of the worst 25 days for emerging market bonds. An ongoing dynamic allocation to the S&P 500 VIX Futures Index Series has also produced better risk-adjusted returns, with statistically significant outperformance.
Click here to read more.
In Europe, ETFs and ETNs linked to the S&P 500 VIX Futures Indices and the VSTOXX Futures Indices collectively have nearly $380 million in assets ), as listed in Exhibit 1 (note: volume is the average daily volume in December 2011).
Compared with the S&P 500 VIX Futures Indices, the VSTOXX Futures Indices show similar diversification properties (details) and sensitivity to VSTOXX spot movements. Since inception, VSTOXX Short Term Futures index has a beta of 48% and the VSTOXX Mid Term Futures index has a beta of 24%. For your reference, the S&P 500 VIX Short Term Futures index has a beta of 47% with the VIX spot, and the S&P 500 VIX Mid Term Futures index has a beta of 23%.
For investors who use the S&P 500 VIX Futures Index Series as a diversification tool in a broad equity portfolio, the term structure decay (especially in the S&P 500 VIX Short-Term Futures Index) is the inevitable cost of a passive hedging strategy (details). This cost has spurred the development of a second generation of “smart” indices and related ETFs and ETNs, which use algorithmic strategies to either roll or package dynamic allocations in volatility.
In Europe, ETFs linked to two indices seek to give investor positive exposure to volatility at reduced holding cost:
- S&P 500 VIX Futures Enhanced Roll Index. Switches between the S&P 500 VIX Futures Short Term Futures Index and a mid-term VIX futures portfolio that holds a rolling position in the third, fourth and fifth month VIX futures contracts. Lyxor issued an ETF (LYMJ GS) on this index.
- Nomura Voltage Mid-Term Index. Allocates between the S&P 500 VIX Futures Mid Term Futures Index and 3-month US Treasury. Nomura issued an ETF (VOLT LN) on this index.
Both indices aim to capture spikes in volatility while mitigating the cost of holding a systematically long volatility position. Exhibit 2 and Exhibit 3 show the historical performance of the two indices between May 2011 and December 2011.
Exhibit 2: Performance Statistics of Cost Effective S&P 500 VIX Futures Indices (May 2011 – Dec. 2011)
Exhibit 3: Cost Effective S&P 500 VIX Futures Indices (May 2011 – Dec. 2011)
Investors often inquire as to why the prices and the price movements for the VIX (spot) Index and the VIX tradable instruments (futures, options, and ETPs) often are different.
For example, yesterday (Tuesday, January 17th) the VIX spot closed at 22.20 and the VIX March futures closed at 25.55 (delayed price quotes are available at www.cboe.com/VIX).
Valuations of VIX futures and options are based on expected values of VIX at the expiration date in the future (rather than the current, or “spot” VIX value). The forward values of the VIX are estimated using the price quotations of S&P 500 options that will be used to calculate the exercise settlement value for VIX on the expiration date (and not the options currently used to calculate spot VIX).
So for example, the current price of the March VIX futures reflects investors’ expectations of what the expected 30-day volatility will be on the VIX futures expiration date of Wednesday, March 20, 2012.
The VIX Index tends to be mean-reverting over long time periods, and the average daily closing value of VIX in the 22 years from 1990 through 2011 was 20.57. The VIX futures prices often are higher than the VIX Index at times when the VIX is at relatively low levels (e.g., under 15). Conversely, the VIX futures prices often are lower than the VIX Index at times when the VIX is at relatively high levels (e.g., above 35).
VOLATILITY OF VOLATILITY
The historic volatility of daily returns in 2011 was 139.9% for VIX spot and 97.0% for VIX near-term futures. The VIX spot index usually has bigger moves than the VIX futures.
LATE 2011 – VIX SPOT AND FUTURES
On August 8, 2011 — the VIX Index (spot) rose 50%, the VIX Aug. 2011 futures rose 25%, and the VIX Nov. 2011 futures were up 10%.
EARLY 2011 – VIX SPOT AND FUTURES
Throughout the months of February through May 2011, the VIX often was in was in contango, except around the time after the March 11 earthquake and tsunami in Japan.
LATE 2008 – VIX SPOT AND FUTURES
On November 20, 2008 — the VIX Index (spot) reached its highest daily close of 80.86, but the VIX Feb. 2009 futures were priced at 54.67 (reflecting investors’ expectations of the value of VIX three months in the future). In October and November of 2008, the VIX Index often was in backwardation.
GROWTH IN VOLUME
Average daily volume in VIX futures grew from 4,543 in 2009 to 47,744 in 2011.
More information on the VIX Index and VIX futures and options is at www.cboe.com/VIX
Trading volume for security futures on the CBOE Emerging Markets ETF Volatility Index (VXEEM; futures ticker VXEM) was 1,106 contracts on January 11th, (the third day of trading). In contrast, the trading volume for VIX® futures was 191 contracts on March 30, 2004, its 3rd day of trading. In addition, options on the VXEEM Index might be launched in future weeks, subject to regulatory approval.
VXEEM SETTLEMENT AND FUTURES VOLUME ON JAN. 11, 2012
While Wednesday’s settlement value for the VXEEM Index (spot) was 29.82, the settlement value for the March 2012 futures was 34.10.
INTEREST IN VXEEM INDEX
Reasons for interest in the VXEEM Index include —
- High Closing Value. The high daily closing value for the VXEEM Index in 2011 was 64.10 on October 3rd, and the low daily closing value was 20.59 on April 20th (in comparison, the high and low daily closing values for the CBOE Volatility Index® (VIX®) in 2011 were 48.00 and 14.62, respectively).
- Large Upside Moves. The VXEEM Index had single-day upside moves of more than 30 percent on three days in 2011 — August 4th (up 34.2%), August 8th (up 35.5%), and Nov. 25th (up 30.4%).
- The daily moves for the VXEEM Index had a correlation of negative 0.81 versus both the EEM ETF and the S&P 500 (SPX) Index. This fact demonstrates that investors could explore the possibility of using the VXEEM as a diversification tool.
The VXEEM Index rose to higher levels than the VIX Index in late 2011.
For more information on VXEEM, please visit www.cboe.com/VXEEM
Just like most humans (monozygotic twins excluded) are not created equals, most VIX futures based exchange-traded products (ETPs) are not equal (At the time of writing this post, there were 43 primary listed ETPs). While there are a number of distinctions and I will attempt to highlight the key areas, but first the few common themes are:
1) They all use swaps to some degree
2) They are all linked to VIX futures (and maybe other assets, but not VIX spot or the VIX Options)
This is not to say that these are the only commonalities, but these are among the most important ones. The key areas of differences for these ETPs are:
1) Structure – These can be structured as exchange-traded notes (ETNs) or exchange-traded funds (ETF), depending on the issuer. Depending on the structure, there may be certain provisions that would be imposed on the investor. e.g. ETNs tend to have an automatic acceleration provision that initiates redemptions if certain trigger thresholds are breached.
2) Exposure – The exposure can vary by maturity i.e. 30-day, 60-day, 5-month, etc.; overcome certain investment impediments such as to reduce roll cost like Term Structure or Dynamic VIX Futures; or for use as an asset allocation tool.
3) Issuer/Sponsor – A number of product issuers globally are offering products – Barclays Capital (through iPath or Barclays ETN+), VelocityShares, ProShares, UBS (Through E-TRACS platform), Source (in Europe), Kokusai Asset Management (in Japan), Citigroup and BetaPro (in Canada)
4) Fees – The fees for different products offered by different sponsors varies. An investor should look through the prospectus to identify “all-in” cost prior to deciding which product to use.
Click here to view the file which lists the 43 products and outlines their structure, AUM, and other high-level characteristics of these products.
Volatility has emerged as an important asset class in its own right over the past decade. Book-ended by two equity bear markets, the past decade (2000 – 2010) saw heightened financial stresses and large losses in investment portfolios. The investment community’s need for tools and instruments to protect downside risks had never been more acutely felt. As the saying goes, necessity is the mother of invention, and this sentiment holds true in the realm of financial engineering.
Since its introduction in 1993, the VIX, the Chicago Board of Options Exchange’s (CBOE’s) volatility index, has become widely considered the “fear gauge” of the market. The VIX measures the implied volatility of S&P 500 index options, representing the market expectation of stock market volatility for the next 30 days. Market participants quickly discovered the value of the VIX index in hedging portfolio risks, since the VIX was found to be negatively correlated with the returns of the equity market, as measured by the S&P 500. Furthermore, the level of correlation increases as the equity market sells off. Due to this asymmetry in correlation, the VIX is an ideal hedge for a long-only equity portfolio.
Recognizing the importance of the VIX index, a host of new products based on the VIX were introduced in the past decade. In 2004, the CBOE Futures Exchange (CFE) introduced futures trading on the VIX, and the CBOE listed an options contract on the VIX in 2006. In 2009, S&P Indices introduced the S&P 500 VIX Futures Index Series, which is now the basis for a growing list of more than two dozen ETNs and ETFs, linked to more than US$ 2 billion in assets (Liu and Dash, 2011). These instruments have driven the VIX’s evolution from a market indicator to a hedging vehicle.
As in the VIX index spot, the S&P 500 VIX Futures Index Series and the S&P 500 tend to move in opposite directions or. As shown in Exhibit 1, while the correlation between the spot VIX and the futures index series is not perfect, it is a healthy 89% for the short-term index and 80% for the mid-term index. More importantly, the correlations of the short-term index and mid-term index to the S&P 500 are -80% and -78%, respectively, closely approximating the -77% correlation of spot VIX with the S&P 500.
Exhibit 1: Correlation of Indices with VIX and the S&P 500 (Dec. 2005 – Dec. 2011)
VSTOXX Short Term Futures Index and VSTOXX Mid Term Futures Index are calculated since late 2010. Despite their short history, they demonstrate high correlation with VSTOXX spot and high negative correlation with EURO STOXX 50. VSTOXX Short Term Futures Index is 85% correlated with VSTOXX and -85% correlated with EURO STOXX 50 since September 2010. VSTOXX Mid Term Futures Index is 81% correlated with VSTOXX and -86% correlated with EURO STOXX 50 since November 2010.
Exhibit 2 below shows that daily falls in the S&P 500 are highly likely to be accompanied by rises in the VIX spot and the two VIX futures indices.
Exhibit 2: Probability of VIX Rises Given Particular S&P 500 Falls (Dec. 2005 – Dec. 2011)
Particularly during periods of market stress, the rise in the two VIX futures indices is substantial, as shown in Exhibit 3. Exhibit 4 shows the diversity property holds in Europe.
Exhibit 3: 20 Biggest Daily S&P 500 Falls from Dec. 2005 to Dec. 2011
Exhibit 4: 10 Biggest Daily EURO STOXX 50 Falls in 2011
In Europe, regional volatility indices have been developed and published to measure the implied volatility in local markets. VSTOXX, VDAX-NEW, VFTSE follow the CBOE VIX methodology and have become the investor fear gauge in the Europe, German and UK markets. Exhibit 1 shows that these indices are highly correlated. Since Jan. 2000, VSTOXX have been 91% correlated with VDAX-NEW and 80% correlated with VFTSE. This reflects the high correlation among the European local equity markets. In the same period, EURO STOXX 50 is 93% correlated with DAX and 89% correlated with FTSE 100. These three European regional volatility indices are moderately (51 – 52%) correlated to CBOE VIX, which reflects the moderate correlation (53% – 61%) between the European and US equity markets.
Exhibit 1: Volatility Benchmark Indices in Europe and US (Jan. 2000 – Dec. 2011)
Exhibit 2 shows that the negative correlation between the equity market and its corresponding volatility benchmark is maintained in Europe. Since the beginning of 2000, VSTOXX is -75% correlated to EURO STOXX 50. This is in line with the correlation (-76%) between VIX and S$P 500. In the same period, the correlation between VDAX and DAX and the correlation between VFTSE and FTSE 100 are both -70%.
Exhibit 2: VSTOXX and EURO STOXX 50 Performance History (Jan. 2000 – Dec. 2011)
The 1.55% gain opening day marked the 29th time that the year’s opening day changed at least a 1% (17 up at least 1%, 20.2%, and 12 down at least 1%, 14.3%) in the last 84 years (since 1929, including today), a 34.5% rate. The high 34.5% rate compares to the 23.9% historical rate of 1% moves (12.1% up and 11.8% down)