AFIN806 - VIX, Volatility Trading & Risk Management - Macquarie

This report provides a comprehensive analysis of the Chicago Board Options Exchange's Market Volatility Index (VIX) and its significance in financial markets. It explains the construction of the VIX, its importance for risk management and hedging, and examines empirical research on the perf...Read More

RISK MANGEMENT AND DERIVATIVES
2018

VIX AND ITS SIGNIFICANCE 1
Table of Contents
Question 1..................................................................................................................................3
Answer 1....................................................................................................................................3
Introduction............................................................................................................................3
Development of VIX..............................................................................................................4
VIX’s importance...................................................................................................................4
Question 2..................................................................................................................................5
Answer 2....................................................................................................................................5
Question 3..................................................................................................................................7
Answer 3....................................................................................................................................7
Performance of the ETP’s......................................................................................................7
Question 4................................................................................................................................10
Answer 4...............................................................................................................................10
Short Volatility Strategies....................................................................................................10
Selling Techniques...............................................................................................................10
Multi-Strategy.......................................................................................................................11
Fluctuations in stocks...........................................................................................................11
Short risk and reward strategy..............................................................................................13
Conventional Analysis..........................................................................................................13
References................................................................................................................................16

VIX AND ITS SIGNIFICANCE 2
Question 1
Answer 1
Introduction
The CBOE volatility index is a common and the prolific measure of the stock market
expectation of volatility implied by S&P 500 index options. The calculation and the
publishing of the index are supervised the Chicago Board Options Exchange. It is also known
as the index of the fear gauge. This form of an index was created in the year 1993 by Robert
F. Whaley who was the professor of the Duke University. As indicated by the CBOE the
assessed instability of the S/P 500 record is estimated by VIX for an aggregate time of the
multi-day at the cash OEX alternative. These incorporate mutual funds, proficient
administrators with the heap of the cash, and the people that make ventures which looks to
benefit from the instability of the market. VIX is a suggested instability in the speech of the
business of the securities. It is similar to the securities which give the yield at the season of
the development. The VIX is frequently alluded to as the "financial specialist fear measure"
(Whaley, 2000).
For the most part when the stock costs are falling and speculators are having a dread the
unpredictability and the record climb in like manner. Like a bond, an investment opportunity
has a model for its valuation and furthermore, the quantity of parameters is locked in which
are to be assessed with abnormal state of precision (Whaley, 2000). To discover the
suggested instability the market cost of the listed alternative is likened with demonstrate
esteem. This inferred unpredictability is accordingly the best benchmark of the normal
instability of the fundamental stock over the rest of the life of the choice. Since VIX depends

VIX AND ITS SIGNIFICANCE 3
on S&P 100 record choice costs, VIX speaks to a market accord of the S&P 100 with
expected instability.
Development of VIX
At the point when the exchanges of the investment of stocks started in the year 1973, Chicago
Board Options Exchange has ensured that the market volatility index can be built by the
option price which can showcase the expectations of the future.
Since the inception of the thought, numerous techniques were proposed by various
researchers and there after Whaley proposed a straightforward approach which focuses on
dealing with the development of the market volatility. This approach is used as a measure for
the future stock price in the financial market. In the same year, the Chicago Board Option
Exchange began to figure out the construction of the CBOE index of the volatility also
known as VIX. The VIX depends on the implicit volatility of the S&P 100 index alternatives
(Cboe volatility index, 2018).
From thereafter the CBOE engaged in the calculation of the various VIX indexes, including
the VIX based on S&P 500 index, CBOE DJIA, CBOE Russell 2000, RVX, NASDAQ 100
volatility index. VIX was launched in April 2008 by national stock exchange and is depends
on Nifty 50 index option prices (Whaley, 2009).
VIX’s importance
The CBOE volatility index is helpful in estimating unpredictable risk of the S&P 500 over a
multi-day target time period for example 3 to 4 days in general. For the purpose of the
calculation the Chicago Board options Exchange works upon the observation of the price and
its behaviour of different call options and the option of the put money on the index of the
S&P 500, where different strike prices as well as the multiple expiration dates are known for
the incorporation of the trading and the weekly options. Further, the weighted average

VIX AND ITS SIGNIFICANCE 4
method is used to calculate the value of the index and the options by the CBOE. The actual
price is the reason for which the VIX becomes the important factor in the financial market for
each investor and individual who invest in the stock options and the index. The relationship
of the VIX with the market situations is inverse relationship in nature. Higher the VIX the
market will drop and vice versa. The investors of the market also use VIX to determine the
risky points and the level of the price of the stock (Whaley, 2013). The scenario of the VIX is
such that when the VIX escalates the prices of few of the share might have fallen already.
The importance or the significance of the VIX can be observed at the broader level altogether
with the pool of the stocks (Chang, Hsieh and McAleer, 2017). The volatility or the risk
factor of the individual stock will differ from that of the pool or group of the stocks. VIX is
also required essentially to understand the graph of the market due to which the investors and
the option traders or the ordinary traders can choose between whether to invest in the stock or
to hold for the future purposes.
Question 2
Answer 2
Another feature of the VIX is to manage the risk of the financial market and therefore, the
risk management also becomes the key essential motive in determining the scenario of the
stocks.
Most of the strategies try to reap the risk premiums options under the volatile market in the
VIX which gives the long haul edge. It has often been observed that the range of the VR may
vary and can be either positive, be negative or neutral. The direction of the VRP is a path
which depicts the performance of the stock options. This way the risk of the investor can be
mitigated by having the approach as discussed above. The volatility risk premiums are

VIX AND ITS SIGNIFICANCE 5
favourable and keeping a record of the same can reduce the risk. There are different positions
which can also be adjusted and balanced according to the market situations through the
alignment of the relationships between the future options, Spot VIX and the volatility of the
S&P 500 (Beuhler, 2016).
Routinely a basic scaling in/out system is significantly outflanking the XIV drawdown
approach. Generally this approach cannot be followed by the investors who are seeking for
the long term. Therefore in order to avoid the risk of the escalating costs the overnight
decisions shall not be taken.
Nobody can anticipate the future, and it becomes hassle when the financial specialists are
involved in the trial and error of the options and try to understand the direction of the volatile
securities which possess the extreme level of the risk. The proactive approach is not suitable
in such a scenario and hence in order to avoid the risk of the loss the investors can turn
towards the reactive approach in which the investors react after analysing the volatility parity
of the security. To identify if the risk is eliminated or not it can be found out by the variances
in the VRP (Cui, Feng and MacKay, 2017).
The size of the security also determines the level of the risks involved. Rationally the
volatility of the risk premium is significant in the cases where the size of the volatility is high.
The exposure for the investor can be increased if the market is in favourable of the investor
and the scaling strategy fits with the future options. The risk adjusted exposure has been
provided when the chances of the profitability can be possible (Hudson, 2017).
Only one out of every odd VIX techniques is presented to the comparable dangers and each
set of risk has its own opportunities and the threats. These varied distinctions can
fundamentally navigate performance of the stock because of economic situations and the
financial markets. Hence, a diversified portfolio of the securities shall be kept in order to

VIX AND ITS SIGNIFICANCE 6
distribute the risks among the different stocks. The potential stocks can be chosen for the
investments and the stocks which are already on hold due to its non-potentiality, its risk can
be mitigated by substituting the risk with the potential ones (Pfund and Fowler, 2017).
The returns from the volatile securities can be generated timely and if a sound strategy is
designed to avail the benefits from the stock for the longer duration. In order to stay away
from the risk that can shake down or can bring a crash in the market the strategy of maintain
a future perspective can be used to decide the magnitude and ultimately the risks can be
managed efficiently (Jadhao and Chandra, 2017)
Question 3
Answer 3
Performance of the ETP’s
The exchange trade volatility products also known as ETP's VIX future contracts came into
existence in the year 2004, recorded VIX option in the year 2006 and volatile ETP's in 2009
and encourages a great deal of chances for the investors to use the class of the assets which
were earlier not allowed to (Buehler and Cusatis, 2018). The short term volatility trading by
the investors will provide the short range of the magnitude and vice versa. Amongst the lot of
examples one such example is the space created through the volatile options. The changes are
reflected however, financial emotion of the investor is also measured (Chen and Lien, 2017).
The future options are measured on the basis of the S&P 500 index and it was evolving and
was in existence since two decades. Yet the idea is not to invest in such securities.
A month ago (June 2016) demonstrated a spike in unpredictability exchanging with the most
elevated offer volume in Exchange-Traded Products (ETPs) connected to the CBOE

VIX AND ITS SIGNIFICANCE 7
Volatility Index or VIX Index ever. This may shock no one, surrendered the vulnerability
prompting BREXIT in any case, while famous, VIX ETPs are not without their complexities
and potential disadvantages. VIX ETPs to fail to meet expectations the VIX record and ought
to accordingly be checked nearly by financial specialists. This colossal week after week
mobilizes; in any case, the VIX tends to chill drastically. The stock was down by 6.4%, and
after a week later higher only by 25% of the time. The stellar performers in the packet of the
ETF were SPY or AGG. Under the first list the returns ranged from almost 19% to 88%
(Roy, 2018). Half the ETP’s on the list are linked to volatility including Rex VoLMAXX
which was accelerated by 98.3% (Rhoads, 2018). The CBOE volatility index reached the
summit of the stock market as the U.S stock market faced a crash by 12%. In order to hedge
their positions to mitigate the future losses, investors bid up the prices. The VIX surged by
115.6 per cent on Monday to 37.32. It rose briefly early Tuesday to over 50, the highest level
since Aug 2015 (Roy, 2018). The VIX then dropped to 22.42, rose to over 45, before fading
to roughly 35.
(Source: Kramer, 2018)

VIX AND ITS SIGNIFICANCE 8
Further the top performers of the VIX in the year 2018 are as follows
(Source: Golden, 2018)
The year seems to be tough in the second half. The SPDR is down by 0.2% while the iShares
Core U.S. Aggregate bond ETF (AGG) has fallen by 1.5% in the year to the date of 10th of
April. The performance seems to be down in comparison to the previous years which
reflected a robust gain of 21.7% and 3.6 % respectively. A lot of equity analysts are givinga
view of the situation as the stock picker market. Yet some of them are also performing at a
super speed such as SPY and AGG. Aside from the VIX products therea re also some kind of
ETP’s that are related to the category of the commodities. The Ipath Bloomberg Cocoa Sub
index Total Return ETN (NIB) and the Iptah Pure Beta CocOA ETN is the commodity pack
which is leading at the next level. The profits were received at the inclining rate and touched
36% in each case. The performance of United States 3x Oil Fund and Long Crude Oil ETN
(UWT) has also been more than par. As impressive as the returns the investors are waiting to
shoot with the VIX ETF or to leverage the commodity with the triple layers.

VIX AND ITS SIGNIFICANCE 9
Question 4
Answer 4
Short Volatility Strategies
Volatility can be described as analyzing and measuring the market index returns or any
change that occur which can be negative or positive is termed as volatility. As the size of the
security changes the risk associated with it is measured accordingly. Volatility can be
measured if there is any deviation in the market index or in another word if the set of
securities that are being used, varies in any condition (Chen, Lee and Hsu, 2018). Active
volatility can be called short-term volatility; short-term volatility is the reason behind the
certain events of the uncomfortable nature that are totally beyond imagination or expectation.
The number of put options will also be affected because of the volatile market and that is the
reason why short-term volatility is called "synthetic" in nature. It can also create imbalance
and that is why strategies are designed according to market (Stanton, 2011).
How Are They Used To Create Returns For The Investors?
In order to make returns through short-term volatile strategies, there are many different ways,
for instance, hedging (Berman, 2017). Hedging comes under the modern or advanced type of
investing, or we can say Hedging is a kind of marketing strategy which is very helpful for the
investors and in which one makes an investment on the basis of the other investments. In
technical terms both the stocks that are being used are correlated negatively. Few option
strategies are explained below:
Selling Techniques
In this situation the dealer accept the costs of the securities will fall and henceforth it can be
purchased back at a reduced cost. Short offering is otherwise called "Shorting" or "going
short". The benefit is derived by the fluctuation in the costs of the buy and sale offer. The

VIX AND ITS SIGNIFICANCE 10
functioning of the market can be analysed by the short selling strategy. The short selling
helps a lot in observing or analysing the ways in which market functions. This strategy
restricts the impact on the investors (Engelberg, Reed and Ringgenberg, 2018). In order to
run the market smoothly and create liquidity, the short term selling is very important and also
to prevent the stocks from escalated bidding at a very high peak, the short selling kind of does
a reality check on the market. Despite all these benefits, shorting can be harmful to the long-
term path and also the upward path in the market. The short selling strategy is kind of an
alarm for the investors which are highly useful in preventing the stocks from being bid up to
the escalated heights. As the investments are bought in the short term duration it provides the
liquidity and also constraints the influence of the price on the mind of the investors.
Multi-Strategy This kind of strategy is very comfortable for the business and in this strategy,
a small amount or sum has to be paid before paying the total amount in advance before
executing the whole transaction. This complete strategy gives benefit to the high cost of
brokerage and therefore the complete expenses made during the sale are lowered and that is
why it is also very helpful while making returns (Fan, Xiao and Zhou, 2018). An investment
is made only after carefully evaluating and examining the associated losses or profits in the
investment. While purchasing the stocks on one side and selling the associate derivatives on
the other side as the call options the profits can be generated and the returns can be earned.
Fluctuations in stocks
The results can be of the two types positive as well as the negative.
The results of profit earned with the arbitration of merger and hedge funds driven by the
events will produce a positive change or movement in the stock. This kind of positive
movements is categorized with an exposure of small put options.

VIX AND ITS SIGNIFICANCE 11
(Source: Motleyfool, 2018)
There is a regression line which has been plotted to evaluate the extra return made in hedge
funds driven by the events with respect to S&P 100. Around the return of 0% in excess, there
is a kink that can be observed in the fitted regression line (Strong and Jeyasreedharan, 2017).
The two important relationships between the excess returns and S&P 100 as well as the
excess returns made by the hedge funds can be clearly seen through the kink because the

VIX AND ITS SIGNIFICANCE 12
regression particularly defines those two valuable events. Despite the positive market and
also the market's performance, a consistent earn has been made by the event-driven hedge
funds (Lee, Liao and Tung, 2017).
Volatility
There are few risks associated with a few short-term volatile strategies that can be
complicated for certain financial marketers and also the fund managers. The difference
between future price and spot price of the stock can be seen as the most basic risks and this
kind of risks occur due to not knowing or unsure of the fact and the basis of a closing of a
hedge (Neuberg and Glasserman, 2017).
Short risk and reward strategy
When no massive losses occur and profits are in excess amount then the short sale is worthy
of all the efforts yet prone to few risks when compared to the security's long position and in
which the amount was invested (Fidelity, 2018). Whenever such kind of situation occurs in
which the value of the stock comes down to zero despite gaining a large profit this kind of
situation leads up the infinite loss.
Emotions of the investors
Sometimes there is a difference between the market's sentiments and the investor's sentiments
and because of this, the investors obtain their own sentiments. For instance, if the market
thinks that the rate of stocks are going to lower down but the investor thinks the opposite or
vice versa then this can be known as opposite sentiments strategy. In this strategy, the biggest
risk that can occur is the idea possessed by the investor can be completely negative or
opposite and stock might be a failure for the investor (Golden, 2018).

VIX AND ITS SIGNIFICANCE 13
Conventional Analysis While investing the investors basically follow the common or current
trade and according to the trend the make the investment, the investors just observe the yearly
trend that comes into existence from time to time in a year and gets an idea of returns that has
been made through stocks and from those trends they try to make the investments despite
carefully observing and analysing the situation deeply and as a result of that there can be few
risks attached to the stocks coming under the short term volatility strategy (Bhansali and
Harris, 2018). Most of the times the investments had been bought by the investors by just
analyzing the previous trends and the normal changes or fluctuations occurring in the stock
price and this has led to many risks because a conclusion cannot be drawn just on the basis of
the trends in the financial market.
Changes in policy
Any changes in the government and the economic strategies, also bring a change in the stock
market too and that is why it can also be counted as a risk because it can also affect the stock
market and can also bring many changes in the current stock market, for instance, changing
the previous trends etcetera under few variable conditions.
How these risks are managed
There are few strategies layered out as a cover to protect the stock market from these risks.
These risks can be prevented to a certain extent through several measures and these options
are, to purchase the put options according to the VIX which can also be compared to the
exposure obtained by the short-term volatility that is related to arbitration of mergers as well
as event-driven strategies (Oltarsh, 2016). Under this strategy, many options are rolled out
because of being active. Portfolio insurance can be defined as the additional change in the
value of the put options that have been bought.

VIX AND ITS SIGNIFICANCE 14
Investing the amount in the strategies associated with hedge fund too can be a solution to the
problem because of their long volatile nature kind of like managing the future or trading
advisors of the commodity (Options Trading, 2018). To realize and observe the varied prices
that are upside and downside, the investors and the financial managers present in the market
follow the strategy derived by the trend. For hedging the portfolio risks, the other traders also
buy volatility.
Parity of risks can also be an important strategy for subsidizing the risks. Under this strategy,
the risks associated with portfolio assets can be equalized because it encourages the low
volatile assets level. To overcome volatility, certain decisions are made in the portfolio based
upon the estimations. All these decisions are sensitive towards volatility and any change will
be risky (Anson and Ho, 2003).
Another solution to lower down the risk is to analyze the trend and all the records of the stock
and their management and the assets in all these times. To increase the returns, the managers
ought to sell the volatility and also attract the funds and try to obtain a high performance. By
selling the high beta stocks and then substituting them with the lower beta names is the best
strategy to deal with volatility (Bekaert and Hoerova, 2014).
Another strategy is risk premium strategy which is widespread. It includes certain measures
to cover the risks and then minimize it. Or in another way, the risk premium allows obtaining
profit from the risk. The term premium can be helpful in earning. All the risk premium
strategies are different for instance a few risk premium strategies contain momentum and the
rest of them works by using tail hedges.

VIX AND ITS SIGNIFICANCE 15
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