AFIN806 - Risk Management and Derivatives: Analyzing VIX Trading

This report provides a comprehensive analysis of the Chicago Board Options Exchange's Market Volatility Index (VIX) and its significance in financial markets. It explores the construction of the VIX, its use in risk management and hedging, and the performance of exchange-traded products (ETPs) related to the VIX. The report also examines short volatility strategies, their potential for generating returns, and the risks they pose to fund managers and financial markets, along with methods for managing these risks. The analysis incorporates empirical research and various perspectives on the VIX as a tool for understanding investor sentiment and market volatility.

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Running head: Risk Management Derivatives
RISK MANAGEMENT DERIVATIVES
Name of Student
Name of University
Author Note

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Table of Contents
Introduction......................................................................................................................................3
1) What is Chicago Board Options Exchange’s Market Volatility Index (the VIX)? How can it be
constructed and why has it become so significant for the financial markets?.................................3
2. How can the VIX or financial products related to the VIX be used for risk management and
hedging in financial markets?..........................................................................................................7
3) What does the empirical research suggest regarding performance of the exchange-traded
products (ETPs) related to VIX?...................................................................................................11
4) Short volatility strategies and risk management........................................................................13
Conclusion.....................................................................................................................................17
References......................................................................................................................................19

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Introduction
Chicago board options exchange market volatility index also known as VIX has been considered
in the year 1993 by Robert E. Whaley who was the professor of Duke University for providing
benchmark of the expected volatility of short term. As per CBOE VIX is used to measure the 30
day expected volatility related to S&P 500 index. Components of the VIX next and near term
call and put options as well as quiet near generally in second and first S&P 500 index
1)What is Chicago Board Options Exchange’s Market Volatility Index (the
VIX)? How can it be constructed and why has it become so significant for the
financial markets?
VIX is the index similarly as DJIA (Dow Jones Industrial Average) which is computed based
over the real time across the trading days. As marked by Whaley, (2009), the only what the
difference between DJIA and VIX is that the VIX basically measures the volatility and DJIA
measures the price. Volatility index has been introduced in the year 1993 having two basic
purposes. First, it intends for providing benchmark of the expected market volatility for a short
term period and facilitate the comparisons of past and present volatility index level with the
historical levels through computing minute by minute values utilising the option prices of index.
Secondly, volatility index also things to provide the index over which the optional contracts and
futures on volatility can be written. As inferred by Fernandes et al.(2014), value of the volatility
lies in a fact of it being negatively correlated with returns of equity market as well as becomes
increasing as the acceleration of market declines start. Due to this long exposure to the volatility
can provide arising portfolio protection levels exactly at the time when the investors are in need

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of that particular protection mostly. As discussed by Whaley, (2000), VIX define empirical
understanding and theoretical knowledge of the implied volatility which has been put into the
play in the year 2004 wherever VIX futures started trading as followed in the year 2006 by
creating options on VIX.
Capital has launched the exchange traded notes which track the future contracts of VIX.
Development of the ETNs or exchange trade notes over VIX has some special relevance for
management industry of private wealth. As observed by Pati et al.(2017), VIX index is therefore,
the calculation which is designed for producing a particular measure of the constant along with
30 days anticipated volatility of US Stock Market which is derived from the real time and mid-
quote prices of the S&P 500 index call as well as put options. VIX is the computed index which
is not only derived depending over stock prices. Rather, as argued by Kocaarslan et al. (2017), it
utilises prices of the options over S&P 500 as well as estimate the quantity of volatility of this
particular options that shall be within current date as well as expiration date of option. Chicago
board options exchange combines prices of several options as well as derives the aggregate
volatility value which is tracked by the index. As addressed by Mariničevaitė and Ražauskaitė,
2015, it is quite significant that volatility index seems to be forward looking because it would
measure the volatility that the investors are expecting to observe. It is merely not the backward
looking index for measuring volatility which is recently realised as suggested by some of the
authors. Conceptually volatility index behaves like yield of a bond to the maturity. Yield to the
maturity is a discount rate which equates price of the bond with its present value of the promised
payments.

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Original volatility index is typically based over option prices of S&P 100 index and not a self-
500 index. According to Figlewski, and Frommherz, (2016), when volatility index was first
introduced in 1993 OEX options intended to be much more actively traded within us which
accounts for almost 75% of entire option volume of index in the year 1992. Critical to usefulness
and timeliness of the implied volatility index the VIX is the only one which should be based over
prices from an active and deep index option market like OEX. Second characteristic of the VIX
is that it is based over prices considering only eight puts and calls of at the money index. If the
courts under real-time computation of VIX are included then it would have diminished the
accuracy and timeliness.
Construction of VIX
Volatility index is the implied volatility within parlance of securities industry. it is quite similar
in the spirit to the yield of a bond to maturity. In order to compute the yield to maturity of the
bond discount rates are searched numerically which equates present value of are bonds coupon
payments which are promised and the principal repayment to current prices of bonds. As
indicated by Gustafsson (2018), computation is permitted through the fact that even if bond
valuation model involves several number of the terms only into maturity becomes unknown.
Amount as well as timing of coupon payments as well as principal repayment is also unknown.
Equating market price of the bond to the model value as well as solving for the yield thus implies
that computed field towards maturity is the implied yield to the maturity.
It is quite best assessment of the market related to expected return rate over the rest of life of the
bond. Just like the bond option for stock index has the valuation model and like a bond model of
valuation stock index option model of valuation consists of different parameters out of which one

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of them is capable for being estimated with higher degree of accuracy. As indicated by Whaley,
(2000), unknown parameter can be considered as expected future volatility of the index. Again,
by equity market price of the index option to the model value as well as solvent for the volatility
implied volatility can be identified. It is the best assessment of the market off expected volatility
related to the underlying stock of index over remaining life of option. Therefore, VIX is basically
computers through minute by minute basis from implied volatility considering aneight near-the-
money, second-nearby and nearby OEX series of options. Therefore, in order to compute the
implied volatility index three things are required:
 optional valuation model
 observed price of option
 values of model parameters accept the volatility ones
Implied volatility are weighted in such of way that volatility index represents implied volatility
of the 30 calendar day at the money OEX option.

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2. How can the VIX or financial products related to the VIX be used for risk
management and hedging in financial markets?
The Chicago Board Options Exchange had created the Volatility Index to mitigate disputes
related to equity and optional investments. This indexing technique determines the uncertainty of
the market by doing a square root of the 30 day period returns and then reviewed in percentage
points. This term expresses the volatility or the change in the market for a short period (Basher
and Sadorsky, 2016). It is essential for investors to analyse the track in which the VIX is directed
to manage potential risks. The investors are thoroughly warned by the analyst who devises the
VIX indexing to mitigate hedging. It tells one number say for example 10 which means how
volatile the equity market defined as the US S&P 500.
As supported by Bongiovanni et al. (2016), this measure explains in a snapshot how much fear
limited as volatility price is in the market right now. It looks at implied volatility in equity
options. The number, the higher the name is, the more worried the market is defined as price
volatility of year into equity options on the S&P 500. It is one useful way to get a quick snapshot
on how nervous the equity markets are based on what's happening in derivatives market or
options market and based on looking at the S&P 500 which is one of the world's most essential
equity indices. Also, Basher and Sadorsky, (2016) discussed that ETF/ETNs can also be a
conservative alternative to solving hedging and risk management. Exchange Traded Funds or
Exchange Traded Notes have been introduced a strategy to track VIX indexing.
There is a different issue that is related to the hedging and management of risks in the market.
The factors may be the volatility of the individual stocks that the investors may be interested in.

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Investors generally prefer long positions in the portfolio, when the VIX is elevated instead of the
S&P500. As of late, (Sonsino et al. 2017) argued that investors prefer to use the VIX indexing
more to understand the volatility of the stocks. It is impossible to invest directly, therefore the
security of the ETP are devised by utilising complex strategies for the future by determining the
potential VIX index. This is due to the fact the contractual obligations often expire after a few
years and require repeated balancing. ENT, on the other hand, is another favourite technique to
trade the VIX indexing.
The investors are in the liberty to expose their selling stocks to obtain a target index in future. It
is relatively cheap option for the investors to buy as well as sell shares and employ any trader
willing to carry it out. The ETN is different than spot VIX because the best way to handle
financial crisis in this situation is to revert the failing phenomenon. Frijns et al. (2016) stated that
the ETN has the power to return that particular situation from the point of spot-VIX. This helps
the trader to save their stocks in times of low volatility. As a hedging strategy, an investor would
purchase or place choices to offset the potential loss in their stock portfolio if they expected the
market to say no, whereas the worth of the investor’s equity portfolio would probably fall with
the general market, the quality of choice would gain in value because the market collapsed. ETF
shares or options are generally used by investors to determine risk management and hedging in
the financial market.
The VIX is watched closely by investors and traders. It's an excellent indicator and measures the
volatility investors expect to check within the close to future. However, there's abundant
discussion on however specifically an investor will use the VIX, and also the degree to that its
use is helpful. Many investors monitor the VIX as a result of it provides info useful regarding

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investor sentiment. Like several alternative sentiment indicators, investors use the VIX to spot
potential market turning points. However, additionally like most sentiment indicators, the VIX
isn’t smart at distinguishing actual market superiority and bottoms.
After launching, VIX is defined as one of the most popular indicators. In spite of being or not
being a precise alternate for risk, this indicator is used by the financial commentator and
investors to measure the tone of attitudes of investors about the market and the most likely way
of instant trading (Bongiovanni et al. 2016). VIX may be used as a means to profits and the
fortification of portfolios. The VIX may be defined as a weighted index. Numerous S&P 500
options of the index are blended with the concept that the superior the premium on the mentioned
options, additional indecision about the route of the marketplace. An activist demonstration is
supposed of what kind of unpredictability is expected in short-term in the market.
People often use VIX as complacency. It is expected that pessimism or the consensus optimism
would not result in a high VIX. Hence, VIX can be considered as an “Uncertainty Index”. A
negative correlation is found between S&P 500 index and the VIX. Importantly, it is to be noted
that the VIX is not technically used to measure the risk straightforwardly. Pastor forecasted
volatility can be used by the investors as a substitute for the chance. It is to be noted that risk
must be enhanced consideration of as the chronological unpredictability of assortment actions,
not the predictable changeable sway all along the conduit. There is a diversity of alternatives for
adding in VIX into the assortments. ETNs are one of the most admired ways to trade the VIX.
ETNs permit investors to purchase and vend instruments considered to imitate specific target
indices. These ETNs hold a collection of rolling VIX futures contracts in the case of VIX (Frijns
et al. 2016).

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Most importantly, it is to be remembered that the ETNs are different to the VIX. It is to be noted
that VIX ETNs can be deviated from the spot VIX trading elevated than they should be at the
time of low volatility. Jadhao and Chandra, (2017) informed that during the time of high
volatility it should be lower as instability is considered as a mean-reverting occurrence. It is to be
remembered that additional drawbacks can be identified due to leveraged VIX ETNs. Due to the
occurrence of repositioning in the portfolio, “Volatility lag” hurts performance. In case of not
coming closer to leveraged volatility ETNs to the replicating authentic performance of VIX,
these items are useful only for holding short terms.
Some factors should be kept in mind of the investors. Elevated commissions should frequently
be carried than even-handedness trades by features and options. A minimum margin should be
maintained by the futures traders. Awareness of different treatments of tax on losses and gains is
required by the investors for the contracts in future. Both investors and time frame should have
to be accurate about the track of instability.
As a result of the European-style practice and the mean-inversion of unpredictability, Frijns et al.
(2016), analysed that VIX alternatives will regularly exchange at bringing down an incentive
than what appears to be fitting amid times of high instability.VIX prospects are inalienably
utilised and tend to duplicate the developments of spot VIX than the ETNs better. Here once
more, however, financial specialists ought to understand that the estimation of the prospects
contract depends on a forward-looking evaluation of VIX. Real prospects can be lower, higher or
equivalent to the spot VIX in light of that viewpoint and the measure of time left before
settlement.

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3) What does the empirical research suggest regarding performance of the
exchange-traded products (ETPs) related to VIX?
In this section the detailed discussion and the illustration of the exchange trade products are
performing in accordance with the VIX during the year. In order to assess the performance and
viability it is important to assess the tail risk insurance or an asset class returns in associated with
the respective investments during the year. As discussed by Bhansali, and Harris, (2018), the
typical performances of any factor are generally measured on the basis of their historical
performances. Hence on the basis of the historical performances the measurement procedures
can be divided into two segments. First of the section includes the measure of the typical VIX
ETP which can track its benchmark index. On the other hand, the second section of the
respective factor which includes the measurement reading the benchmark can perform as an asset
class (Whaley, 2013).
The empirical research also shows that the most traded VIX exchange traded products in
respective of their performances and price discovery along with the hedging ability and trading
strategy. The VIX ETPs also trades their benchmark indices well associated to their asset
management procedures. Hence, Bekaert, and Hoerova, (2014) added that the factors and ETPs
are exposed to identical time decay which is high negative expected returns along with the
indices. Thus the applications of these are not suitable in terms of buy and hold investment
during the year. However it is also observed that these factors give rise to highly profitable
trading strategies for the time being. Although the ETPs are negatively correlated with the S&P
500 the ETPs have performed poorly as a hedging tool and their inclusion in a portfolio which is

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based on S&P 500 will decrease the risk-adjusted portfolio regarding the associated factors
performances over the period (Simon, 2017).
Tracking performances of the ETPs in relation to the VIX
The empirical research suggested several factors and aspects that needs to be identified and
understood in order to get the accurate understandings and implications of the ETPs in relation to
the VIX. The research suggested that the VIX ETFs have grossed their highest amount of share
trading in the previous accounting year. VIX ETPs are often observed to be performing
differently in comparison with the VIX index. Simon(2017) further conducted researches also
suggested that there exist direct relationship between the tracking errors and the time to maturity
of the associated VIX futures. The research determined the fact that the shorter dated futures
should be able to track and measure the VIX index better.
In this context several measurements and suggestions are also to be provided in order to
accurately evaluate the suggestion provided by the empirical researches made on te factors
aspects related with the VIX ETPs. In this context, Eraker and Wu, (2017) also discussed that in
the previous accounting year the volatility trading have resulted their highest margins of trading
and also included the highest number of share volume trading in Exchange Traded Products in
relation with the CBOE Volatility Index or the VIX index in the recent history of trading. The
results does not impacted with such surprises as the Brexit valuations and trading have led to
several uncertainties regarding the trading in the same period. However the VIX ETPs are also
traded with several complexities and potential drawbacks (Stanton, 2011).
There exist further suggestions which include several good reasons for the differences that were
measured in the performances of the factors. It is mainly because the VIX ETP track VIX future