Besides commodities, volatility is another example of the application of futures-based indices. Spot volatility, as measured by the VIX, is not tradeable as the index represents the weighted average of implied volatilities of various options on the S&P 500. Prior to the introduction of VIX futures on the Chicago Board Options Exchange in 2004, equity volatility was only traded by sophisticated counterparties by way of over-the-counter instruments, such as variance swaps. Since then, VIX futures and options have gradually gained acceptance but trading was confined principally to sophisticated players in the derivatives market. More recently, the ongoing economic downturn and the introduction of S&P VIX Futures indices in 2009 have made volatility a popular alternative asset class with many products offered in this space (Dash and Liu, 2010). Interestingly, the development of ETNs and ETFs linked to these indices has also significantly enhanced the liquidity of the underlying VIX futures.
It is well-known that implied volatility exhibits a strong, negative correlation with equity markets and often spikes up during market turmoil. To that end, volatility indices serve to provide directional exposure to spot VIX, either as a trading vehicle or as a hedging instrument to attenuate tail risk events. From this, it follows that the sensitivity to the spot VIX, namely the beta, has to be a critical factor in the design of volatility indices. In addition, as in commodity indices, the liquidity of the underlying futures contracts as well as the costs associated with the rolling of the futures are also important considerations.
As can be observed in the figure below, the liquidity of VIX futures, as measured by average daily trading volume, is concentrated in the one-month and two-month contracts, and drops quickly thereafter. Moreover, the volatility beta of the VIX futures indices and the roll costs fall as maturities lengthen. These characteristics indicate that there are trade-offs between liquidity, beta exposure to spot VIX and roll costs.
This is an excerpt of an article published in the September/October issue of the Journal of Indexes Europe by Xiaowei Kang, Director, Index Research & Design at S&P Dow Jones Indices and Daniel Ung, Associate Director, Index Research & Design at S&P Dow Jones Indices. The full article can be accessed at www.indexuniverse.eu/joi.