Wednesday, April 20, 2011

The VIX, VIX Products and Replication

Jared Woodard of Condor Options is out with a post today, Why I’m Not Worried About VIX Derivatives, in which he reviews some recent FT Alphaville commentary about the difficulty in valuing VIX futures, the idiosyncrasies of various VIX-based products, the shortcomings associated with a synthetic VIX, and the implications for volatility as an asset class.

Over the years (I still can’t believe I am in my fifth year of blogging) I have addressed all of these issues to one degree or another, but seeing some of the points being raised by Jared and the FT Alphaville staff, it looks like time to take a deeper dive into these issues, some related sidebar issues, and make an effort to come up with some sort of unified theory of volatility products. Of course I can’t possibly cover all of the space today, but I can at least dive in.

For starters, here are the four FT Alphaville articles referenced by Jared, which are authored by Izabella Kaminska, Tracy Alloway, as well as Theo Casey of Futures & Options World:

The question that seems to be on everyone’s mind right now is why the VIX is “so low.” Better yet, investors would like to know how low the VIX will go and what some reasonable expectations are for the VIX for the balance of 2011.

First, let me dispense with the idea that the VIX is low. With 10-day and 20-day SPX historical volatility just over 8 and 100-day SPX HV below 12, the VIX is actually a little inflated relative to current measures of realized volatility, even factoring in the standard risk premium.

Second, the VIX is currently in the 32nd percentile of VIX readings going back to 1990. This means that in the 21 years of VIX historical data, the index has been below its current level about one out of every three days.

Third, I think most investors are struggling most with the idea that even with low realized volatility, we have huge issues facing the global economy, including the European sovereign debt crisis, a Japanese nuclear disaster and ripple effect that is far from contained, rising oil prices, strong inflationary pressures across the globe, a huge Fed balance sheet and a host of other formidable threats to economic and political stability.

Fourth, investors are still reeling from the financial crisis of 2008 and the many ways in which that crisis shaped not just a new economic landscape, but a new way in which investors look at the investment world (i.e. "disaster imprinting") and the risks associated with it.

The knee-jerk reaction for many investors is that the VIX is naïve, misguided or perhaps not as relevant as many think it is.

In the links below I address a number of the issues raised by the FT Alphaville staff and Jared. I hope readers will find some insight in these archived posts below, but I promise that in the weeks to come, each of the issues noted above will receive a much more thorough treatment.

In the meantime, do not be surprised if the VIX stays “too low” for an extended period…

Related posts:
Disclosure(s): neutral position in VIX via options

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