Derivatives: Examining VIX Futures, Options, and Hedging Strategies

This report provides a comprehensive analysis of VIX futures and options, examining their introduction by the Cboe Futures Exchange and their role in providing market participants with opportunities for volatility trading strategies, portfolio diversification, alpha generation, and risk management. It discusses the availability of weekly and monthly expirations, the process of VIX index settlement, and the use of VIX futures as an effective tool for diversifying portfolios and hedging equity returns. The report also explores the increasing assets and volume of exchange-traded products connected to VIX futures contracts, highlighting their use as a hedge against stock market losses and the negative correlation between the S&P 500 and VIX changes. Furthermore, it addresses the criticisms of VIX as a predictor of future volatility and the concerns about potential manipulation in its settlement calculation, while also emphasizing the importance of active strategies in VIX futures trading to benefit from volatility increases and protect against falling equity market volatility.

Derivatives

Table of Contents
Question 1.............................................................................................................................................2
Question 2.............................................................................................................................................3
Question 3.............................................................................................................................................4
References.............................................................................................................................................6
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Question 1
VIX futures were being introduced by Cboe Futures Exchange which provides participants of
the market with the ability of trading volatility product on the basis of the VIX index
methodology. The VIX futures show the estimate of the market value of VIX index on
different expiration dates in future. Thus, VIX futures provides participants of the market
with wide variety of opportunities of implementing their ideas by applying volatility trading
strategies which consist of portfolio diversification, alpha generation and risk management
(Dzekounoff, 2010). Weekly and monthly expirations in the VIX futures are being available
and traded nearly 24 hours per day and five days a week. VIX index is being estimated and
disseminated in a day which provides participants of the market with the information on the
real-time volatility whenever news displays. VIX weekly futures started trading in 2015 on
CFE and provided the participants of the market with the opportunities of establishing short
term VIX position and manage the timing of their trading and hedging activities. For futures,
weekly expirations are listed generally on Thursday and on Wednesday it expires. VIX
weekly futures have similar contract specifications as the expiring monthly VIX contracts
(Huang, Tong and Wang, 2018).
The process of VIX index settlement is structured after the settlement of the S& P 500 index
options process. The final settlement of VIX options and futures value is estimated on the
morning of the expiration date through the special opening quotation of the VIX index by
applying the opening price of the portfolio of the SPX options which expires after 30 days
(Huskaj and Nossman, 2012). The option's opening prices are estimated through a proprietary
auction mechanism of Cboe. The participants of the market are provided with the mechanism
of purchasing and selling SPX options at prices that are being used to estimate the final
settlement of VIX derivatives value and the settlement process of VIX index is tradable.
VIX futures are considered to be an effective tool of diversifying portfolios, equity hedge
returns and spreading realized versus implied market volatility. It also enables the speculators
of the market to trade volatility which is independent of the level of the stock prices or of the
direction. VIX futures are futures standard contracts on 30 day forward implied volatilities of
S&P 500 index.VIX futures are generally being cash settled and not like the futures on the
commodities that have no physical delivery (Sinclair, 2013). The account of the market
participants on the date of the settlement would simply be debited or credited on the basis of
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the difference between the settlement price and purchase price. The future’s future value is
being obtained from the carrying cost relationship between the underlying futures and stock
index. The VIX future’s fair value cannot be estimated using the same relationship because
there is not carrying cost between a position in VIX futures and VIX. The fair value of VIX
futures is estimated by pricing 30-day forward variance that underlies the settlement price of
VIX futures. The future price relies on the trader sentiments because it allows movements of
the VIX index.
Question 2
The exchange-traded products are connected to the futures contracts on the CBOE volatility
index that increased in assets and volume since 2009. The increase in the volatility based
exchange-traded products is due to the concept that they provide a hedge against the losses of
the stock market. It is significant to know that the VIX is the forward measure of the
volatility. It shows the expectations of the investors for future market volatility (Hülsbusch
and Kraftschik, 2018). Therefore, if the investors have become fearful then the demand for
the portfolio insurance would increase that leads to an increase in the price of VIX. There is a
negative correlation between the changes in the S&P 500 and changes in VIX. The negative
relationship is the attempts made by the investor to hedge the stock portfolios with the use of
VIX (J. Fahling et al., 2018). The investors can gain exposure only to the VIX through
options and futures contracts where the payoffs rely on future VIX values. VIX futures that
are based on ETPs give access to VIX futures markets in exchange-traded form.
The returns on VIX are being affected heavily because VIX futures are traded on contango
where the future prices are more than spot prices. The loss of huge stock market leads to
increase in the VIX and ETPs tracks the VIX futures in short term which is not an effective
hedge for the stock portfolios because of the negative roll accumulated yield by the futures
based on ETPS (Lin and Lin, 2016). The futures in medium terms suffer minimum from the
negative yield roll than the nearest month which is because the long term future contracts
prices decrease rapidly with the passage of time. The investment in the vitality ETPs
decreases the returns on the hedged stock portfolio and reduces the Sharpe ratio. The result
depicts that the VIX futures in short term fail to provide an appropriate hedge against the
stock market fluctuations.
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The risk can be hedged by purchasing put options which cover the value of the portfolio or
selling the futures contracts. The put option insurance is considered to be very much
expensive. The put options expire which needs repurchase of puts in order to keep the longer
life of the hedged portfolio. The selling of futures stock index against the portfolio locks in
the price (Swedroe, 2013). The losses in the portfolio can be offset by profits in futures and
profits in a portfolio can be offset by losses in a future hedge in short term. VIX futures are
considered to be cash settled and at the maturity stage, it provides direct exposure to S&P 500
volatility in 30 days. The volatility increases due to the market stress periods which make
VIX futures as attractive hedging tools. In VIX futures, the passive investments are
considered to be costly because of two reasons that are negative carry and strong mean
reversion volatility properties.
The negative carrying cost is the function of the term VIX futures structure. The VIX terms
structure is positively sloped and at the time of maturity the VIX futures contracts are
replaced with the contract with longer date and investors tend to buy high and sell low.
Volatility reverts which require an active approach to profit from the increase in VIX futures
(Simon, 2016). The passive allocations after the financial crisis to VIX futures had depicted
losses because the equity market faced volatilities which reverted towards the long term and
decreased averages. VIX active future strategies can lead to some issues such as tactical
signal hedge derived from the VIX index term structure which allows the investors to take the
benefit of an increase in VIX and offering protection during the periods of falling or low
equity market volatility. It can be achieved by not taking the investment decision in VIX
futures until the signal is shown.
Question 3
VIX is being criticized as the prediction of future volatility.VIX measures the current price of
the index options. It is being criticized that the predictive power of the forecasting volatility
models is being similar to the pain vanilla measures like the simple past volatility. In the
volatility products, the traders have debated whether the calculation of settlement can be
influenced artificially by someone such as increasing the price of options (Frijns, Tourani-
Rad and Webb, 2015). It has been found that there were situations before the settlement that
large option sells or buy orders did not happen at other times. Many people criticized that loss
of money can be faced by the traders because of the alleged manipulation. It is being found
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that different parties influenced the VIX by replacing with the S&P order options with the
intention of moving the VIX settlement price.
VIX estimates the volatility which is expected in the S&P 500 index. The traders pay more
money for the options when they expect that the prices would be volatile and anyone can
compute volatility implied from the option prices (Kent, 2019). VIX examines the trading
prices of out of money cal and put options on the S&P 500 and estimates the average for the
implied volatility. VIX is being used as the reference for the price of derivatives and if a
trader wants to bet the stock market then the volatility will decrease or increase while selling
or buying options or futures on the VIX. The products are seen to be cash settled and VIX is
considered to be not a thing that can be purchased and if the option ends up in cash then the
amount is to be paid for the VIX value at settlement. VIX volatility index at the settlement
time increases the spikes volumes on S&P 500 index options and out of money can be used
only for calculating the VIX (Levine, 2017). Some portfolio managers and practitioners
completely dismiss or ignore the volatility forecasting models.
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References
Dzekounoff, D. (2010). Understanding VIX futures and options | Futures Magazine. [online]
Futuresmag.com. Available at: http://www.futuresmag.com/2010/08/17/understanding-vix-
futures-and-options [Accessed 2 Mar. 2019].
Frijns, B., Tourani-Rad, A. and Webb, R. (2015). On the Intraday Relation Between the VIX
and its Futures. Journal of Futures Markets, 36(9), pp.870-886.
Huang, Z., Tong, C. and Wang, T. (2018). VIX term structure and VIX futures pricing with
realized volatility. Journal of Futures Markets, 39(1), pp.72-93.
Hülsbusch, H. and Kraftschik, A. (2018). Consistency between S&P500 and VIX derivatives:
Insights from model-free VIX futures pricing. Journal of Futures Markets, 38(8), pp.977-
995.
Huskaj, B. and Nossman, M. (2012). A Term Structure Model for VIX Futures. Journal of
Futures Markets, 33(5), pp.421-442.
J. Fahling, E., Steurer, E., Schädler, T. and Volz, A. (2018). Next Level in Risk
Management? Hedging and Trading Strategies of Volatility Derivatives Using VIX
Futures. Journal of Financial Risk Management, 07(04), pp.442-459.
Kent, D. (2019). VIX index: What Is It And How Is It Used? - Stocktrades. [online]
Stocktrades. Available at: https://www.stocktrades.ca/vix-index/ [Accessed 2 Mar. 2019].
Levine, M. (2017). VIX Trading, Hoaxes and Blockchain. [online] BloombergQuint.
Available at: https://www.bloombergquint.com/markets/vix-trading-hoaxes-and-blockchain
[Accessed 2 Mar. 2019].
Lin, Y. and Lin, A. (2016). Using VIX futures to hedge forward implied volatility
risk. International Review of Economics & Finance, 43, pp.88-106.
Simon, D. (2016). Trading the VIX Futures Roll and Volatility Premiums with VIX
Options. Journal of Futures Markets, 37(2), pp.184-208.
Sinclair, E. (2013). Volatility Trading. 8th ed. New York: Wiley.
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SWEDROE, L. (2013). Do VIX futures hedge stock market risk?. [online] Cbsnews.com.
Available at: https://www.cbsnews.com/news/do-vix-futures-hedge-stock-market-risk/
[Accessed 2 Mar. 2019].
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