Risk Premia and the VIX Term Structure

Summary:

VIX futures term structure does not represent future volatility expectations, but rather the price of variance risk.

Relevance to Cassini:

This paper supports the slope of the term structure as the most important factor for determining the future returns of a VIX futures contract. The author further affirms the evidence that in the case of VIX, the term structure does not purely reflect expectations of the VIX path as many other storable commodity futures do.

Relevant Quotes:

“The shape of the VIX term structure conveys information about the price of variance risk rather than expected changes in the VIX, a rejection of the expectations hypothesis. A single principal component, Slope, summarizes nearly all this information, predicting the excess returns of synthetic S&P 500 variance swaps, VIX futures, and S&P 500 straddles for all maturities and to the exclusion of the rest of the term structure”

“The second principal component ‘Slope,’ summarizes nearly all information about variance risk premia in the VIX term structure.”

The VIX Futures Basis: Evidence and Trading Strategies

Summary:

Utilizing an S&P hedge to neutralize some of the directional components in VIX futures returns, Simons concludes that the risk premia in the VIX futures term structure provides an independent source of returns that can be harvested.

Relevance to Cassini:

This paper demonstrates the efficacy of using the VIX term structure to profit from the convergence yield available. It further shows that some of the directional components can be hedged and continue to produce attractive risk-adjusted returns relative to other risk assets.

Relevant Quotes:

“This study demonstrates that the VIX futures basis does not have significant forecast power for the change in the VIX spot index from 2006 through 2011 but does have forecast power for subsequent VIX futures returns. The study then demonstrates the profitability of shorting VIX futures contracts when the basis is in contango and buying VIX futures contracts when the basis is in backwardation.”

Volatility Derivatives in Practice: Activity and Impact

Summary:

The CFTC uses its unique and proprietary access to regulatory data to determine which classes of investors are possibly providing the underlying supply and demand to VIX futures, and whether any imbalances are distorting the term structure.

Relevance to Cassini:

The majority of the term structure of VIX futures is not driven by a supply and demand inefficiency, but there are times when there is some additional premium due to a temporary imbalance. Furthermore, it shows that asset managers are the primary purchasers of long VIX futures contracts. As Dodd-Frank takes effect, the short positions will likely continue to move from the realm of dealers, toward that of funds like Cassini. Funds will be beneficiaries of the risk premium that used to be harvested solely by the investment banks.

Variance Term Structure and VIX Futures Pricing

Summary:

VIX Futures can be arbitraged to SPX options, with a few assumptions approximated by the SPX option skew.

Relevance to Cassini:

This paper supports that VIX futures prices can be loosely arbitraged to the SPX options-implied volatility term structure. Therefore, the dynamics of the VIX futures curve are influenced by the option pricing models’ assumptions about option-implied volatility, mainly that it is mean-reverting. Another implication is that the liquidity in the VIX futures market can be backed by the liquidity of the SPX options market.

The Shape and Term Structure of the Index Option Smirk: Why Multifactor Stochastic Volatility Models Work so Well

Summary:

This study analyzes option models, specifically the implied-volatility smirk and term structure. It concludes that the implied-volatility term structure is an independent factor in option pricing and needs to be modeled separately from the skew structure.

Relevance to Cassini:

The relevance to Cassini is that traditional option pricing models, like Black-Scholes, do not directly address term structure of implied volatility. Newer, two-factor stochastic option pricing models can address it, and model it as a stochastic, mean-reverting, volatility clustering series. This results in the term structure of implied volatility being upward sloping 80% of the time. These models better fit the empirical data, and further confirm that market practitioners are indeed using stochastic, mean-reverting inputs for pricing longer-duration, option-implied volatilities.

Relevant Quotes:

“Implied volatilities for at-the-money options also contain a term structure effect that cannot be explained by the Black-Scholes model … this stylized fact is known as the leverage effect. The leverage effect is important for equity index option valuation, because it increases the probability of a large loss and consequently the value of out-of-the-money put options.”

“The leverage effect induces negative skewness in stock returns, which in turn yields a volatility smirk … stochastic volatility models can also address term structure effects by modeling mean reversion in the variance dynamic.”

Flights to Safety

Summary:

Identification and characterization of flight-to-safety assets: TED spread, Yen, USD, VIX, Treasuries, Short Exposure to Commodities, etc.

Relevance to Cassini:

Shows that VIX is a flight-to-safety asset, and therefore other flight-to-safety assets could likely be useful in hedging a portion of the risk in a short VIX portfolio, if priced attractively relative to the VIX futures premiums.

Relevant Quotes:

“FTS episodes coincide with increases in the VIX and the Ted spread, decreases in consumer sentiment indicators and appreciations of the Yen, Swiss franc, and US dollar … with the disappointing finding that nearly all hedge fund styles, the event-driven ones in particular, have negative FTS betas.”

“We conclude that hedge funds, with the exception of the Managed Futures category, do not hedge against FTS events.”

“On average, FTS episodes comprise less than 3% of the sample, and bond returns exceed equity returns by about 2.5 to 4% on those days. FTS events are mostly country-specific as less than 25% can be characterized as global.”

The Information Content of the Implied Volatility Term Structure on Future Returns

Summary:

Examines the information contained in the VIX term structure and finds that it contains valuable information about future excess returns in equity portfolios.

Relevance to Cassini:

The information contained in the term structure is statistically significant when applied to tactical risk asset allocation. This is also true when used for positioning a VIX futures portfolio.

Relevant Quotes:

“Our findings reveal that the information content of the term structure plays an important role in the prediction of excess returns … Furthermore, a positive relationship is also found to exist between excess market returns and the squared VIX term structure, which is consistent with the empirical results of Bakshi et al. (2011).”

“We use three alternative empirical approaches to support our theoretical model, from which we find that the squared VIX term structure is more informative than the squared VIX level, although predictive power is found to exist for both factors across various time horizons.”

The VIX Premium

Summary:

Analyzes the premium in VIX futures and analyzes how the premium increases or decreases as VIX itself increases or decreases.

Relevance to Cassini:

The term structure of VIX futures, as represented by the premium, provides clear risk/reward information as well as predictive power that enables active management alpha to be achieved above and beyond a passive short VIX portfolio, such as CBOE’s VPN or VPD.

Relevant Quotes:

“The VIX premium is a simple, measurable quantity which predicts returns in the VIX futures markets. It tends to decrease or stay flat on impact of a risk shock, only increasing in the following few weeks. Dynamics of trader positions appear to be related to premium dynamics. Trading the VIX premium would have allowed a short VIX investor to side-step the financial crisis, or even buy insurance against it, very cheaply. Premium dynamics also help explain asset prices in fixed-income markets.”

Analysis of VIX Markets with a Time-Spread Portfolio

Summary:

This paper derives a method of using S&P 500 options to produce a model-free link to the VIX futures term structure. This is further proof of the ability to arbitrage VIX futures to the appropriate basket of SPX options along with a dynamic hedge.

Relevance to Cassini:

Additional evidence of the link between SPX option-implied volatilities and VIX futures term structure.

Relevant Quotes:

“The time-spread portfolio is a powerful tool because it provides a model-free link between derivative prices for SPX and VIX. Time spreads can be computed from SPX put options with different maturities, which results in a term structure for squared volatility.”

VIX Futures Basis Trading: The Calvados-Strategy 2.0

Summary:

This paper examines a simplistic mechanical trading strategy to take advantage of the convergence yield in VIX futures. It is similar to the David Simon paper, though approached from a more practical trading strategy focus rather than an academic proof of concept.

Relevance to Cassini:

This paper demonstrates another mechanical VIX strategy that generates profit from the convergence yield in VIX futures. It is done in a sub-optimal manner, but even so, produces attractive returns relative to other risk assets.

Relevant Quotes:

“The authors demonstrate that the VIX futures basis does not have significant forecast power for the change in the VIX spot index, but does have forecast power for subsequent VIX futures returns. It is especially profitable to short VIX futures contracts when the basis is in contango.”

Does Historical Volatility Term Structure Contain Valuable Information for Predicting Volatility and Index Futures?

Summary:

Analyzes the term structure of volatility and its tendency to be upward sloping when VIX < 20, and downward sloping when VIX > 30. It goes on to classify the quintiles of VIX term structures and develops a simplistic trading strategy around them.

Relevance to Cassini:

The term structure of VIX is impacted by the absolute level of VIX relative to the long-run mean and median, and therefore by realized volatility. Additionally, it develops a simplistic strategy which outperforms S&P 500 on a risk-adjusted basis.

Are VIX Futures ETPs Effective Hedges?

Summary:

The ETPs that hold VIX futures long serve as poor hedges to long equity exposure.

Relevance to Cassini:

Demonstrates that VIX instruments do respond as hedges in a short time-frame. But over any period longer than a few days, the loss due to the premium decay results in them being overly expensive relative to their ability to hedge unless used with near perfect timing.

Relevant Quotes:

“We find that while the VIX increases when large stock market losses occur, ETPs which track short term VIX futures indices are not effective hedges for stock portfolios because of the negative roll yield accumulated by such futures-based ETPs.”

VIX Exchange Traded Products: Price Discovery, Hedging and Trading

Summary:

Reviews the performance of the VIX-based ETPs, concluding that they make for very poor, long vol hedges.

Relevance to Cassini:

This paper supports the concept that long VIX futures do not provide a cost-efficient hedge for S&P 500 risk, and that it would be more efficient to just hold less S&P rather than hedge with VIX-based ETPs. The converse is that these instruments are profitable to short when short can outperform a traditional long S&P portfolio.

Relevant Quotes:

“Despite being negatively correlated with the S&P 500, the ETPs perform poorly as a hedging tool; their inclusion in a portfolio based on S&P 500 will decrease the risk-adjusted performance of the portfolio.”

“VIX futures are consistently overpriced relative to the subsequent moves in the underlying VIX index.”

“However, because it is unfeasible to trade the VIX index directly, the usual futures pricing relationship based on cash-and-carry arbitrage does not hold.”

Volatility as a New Class of Assets? The Advantages of Using Volatility Index Futures in Investment Strategies

Summary:

Analyzes the benefits of including long VIX futures hedges in a portfolio for the 2006-2013 time frame. Concludes that they help during the financial crises, but create significant drag in every other period.

Relevance to Cassini:

Further evidence that VIX futures are a very cost-inefficient vehicle to use as a hedge, and therefore could potentially be a source of profit if shorted instead.