Friday, November 5, 2010

Interesting New Leveraged Volatility ETN Coming from Citi

Yesterday in Citi Files to Offer Long/Short Alternative to VIX ETFs, Murray Coleman of Barron’s tipped me off to a new ETN filing from Citigroup for the C-Tracks Citi Volatility Index ETN, which has been assigned the ticker CVOL.

I’d like to highlight two nuggets from the preliminary pricing supplement.

First, an overview:

The Index is a new index established by Citigroup Global Markets Inc., as index sponsor. The Index is published by the Chicago Board Options Exchange (the “CBOE”) and is a measure of directional exposure to the implied volatility of large-cap U.S. stocks. As a total return index, the value of the Index on any day also includes daily accrued interest on the hypothetical notional value of the Index based on the 3-month U.S Treasury rate and reinvestment into the Index. The methodology of the Index is designed to produce daily returns that are correlated to the CBOE Volatility Index (the “VIX Index”), which is another measure of implied volatility of large-cap U.S. stocks. However, the Index is not the VIX Index, and returns on each of these indices may differ substantially.”
Second, some of the details of how this ETN works:
“The Index methodology uses a combination of returns on (a) a long exposure to third- and fourth-month futures contracts on the CBOE Volatility Index (the “VIX Index”) published by the Chicago Board Options Exchange, Incorporated (the “CBOE”) (the “VIX futures contracts”), multiplied by a factor of two, (b) a weighted short position in the S&P 500® Total Return Index (Bloomberg L.P. ticker symbol “SPXT:IND”) (the “S&P 500® Total Return Index”), as reduced by the Treasury Return determined by the formula described below under “—Composition of the Index—Treasury-Based Interest Accrual Component; Calculation of the Index Level” (the “Treasury Return”) and (c) an interest accrual on the notional value of the Index based on the 3-month U.S Treasury rate and reinvestment into the Index, all as described below.
The weighting of the S&P 500® Total Return Index short position is determined monthly by a regression over a 6-month backward-looking window of (a) the difference between the VIX Index daily returns and twice the daily returns of the relevant VIX futures contracts versus (b) the S&P 500® Total Return Index as reduced by the Treasury Return. See “Risk Factors Relating to the C-Tracks—The Index May Underestimate the Volatility Levels” in this pricing supplement.”
In a nutshell, the forthcoming Citi product tries to find a balance between the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) by using an intermediate point in the VIX term structure and adding leverage. The biggest problem with VXX has been the negative roll yield associated with the persistent contango in the VIX futures. At the other end of the spectrum, the problem with VXZ is that it moves like molasses and typically captures only a small fraction of any move in the VIX and VXX. See Lost in Translation: VXX and VXZ for an overview.

What the Citi product apparently hopes to do is to move down the VIX futures term structure to minimize roll yield and use leverage to amplify the changes in volatility in that portion of the term structure.

While there is no date set for the launch of the new Citi 3-4 month 2x volatility ETN, I am very much looking forward to its launch and firmly believe that it will provide the basis for some very interesting volatility trading opportunities, both on its own or in combination with VXX and VXZ.

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Disclosure(s): short VXX at time of writing

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