A New Application for VIX®: Hedging Bond Portfolios

Equity volatility is frequently used to hedge equity portfolios, but some bond portfolios may also stand to benefit from an allocation to equity volatility.   Read the latest research paper from S&P Indices to learn why corporate and emerging market bonds may enjoy hedging benefits.  Read more…

Contango and Roll Cost

 

Although VIX spot is generally mean reverting, the S&P 500 VIX Futures indices are return generating time series that trend down for the majority of their history. This downward trend is particularly obvious in the Short Term index.

This is because the price received from the sale of the shorter term contract is generally less than that paid for the longer term, as expected VIX is generally greater than current VIX. Additionally the spread between the shorter term futures and the longer term futures is generally bigger on the front month contracts.

This feature is not unique to VIX futures. Commodity markets often experience these conditions, a phenomenon known as contango.

Roll cost is inevitable when the market is in contango since one futures contract has to be rolled into a longer term one prior to its expiration. The continuous daily roll of the two futures indices only spread the cost throughout the month. It does not necessarily change the magnitude of the cost.

In the S&P 500 VIX Short-Term Futures Index, contango occurred 77% of the days since inception.  On average, 0.18% of the portfolio value was lost daily by rolling from the first month futures to the second month futures.

In the S&P 500 VIX Mid-Term Futures Index, contango occurred 64% of the days since inception.  On average, 0.07% of the portfolio value was lost daily by rolling from the fourth month futures to the seventh month futures.

ETPs that track these two indices are trading vehicles, not buy-and-hold products.

VIX futures indices only track a fraction of VIX spot return

It has been widely observed that the S&P 500 VIX Short Term and Mid Term Futures indices track only a fraction of the VIX spot return. For example, on 8/8/2011, in response to the US Teasuries downgrade, the S&P 500 fell 6.88%, the biggest drop in 2011 (fingers crossed!). On the same day. VIX spot jumped 40.55%, but the Short Term index only jumped 17.44% and the Mid Term index jumped 6.96%.

Overall, the Short Term index has a beta of 43% with the VIX spot, and the Mid Term index has a much lower beta of 21%. This is because the futures market is usually less sensitive than the spot to equity market movement. Furthermore this sensitivity declines with longer dated contracts.

Note that we see NO loss in correlation or diversification properties in the futures market, however. The correlation of the Short Term and Mid Term index to the S&P 500 are -80% and -78%, respectively, closely approximating the -76% corrleation of the spot VIX with the S&P 500.

Similar correlation means similar diversification;

Lower beta means higher hedge ratio.

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