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Construction of the VIX

Discuss About The Market Reaction To Macroeconomic News.

According to the Franklin D. Roosevelt “the only thing we have to fear is fear itself”. The volatility Index or VIX, is an index created by the Chicago board operations in the year 1993 by the professor of the duke university Robert F. Whaley to provide the benchmark of the short term volatility. According to the CBOE the estimated volatility of the S/P 500 index is measured by VIX for a cumulative period of the 30 day at the money OEX option. These include hedge funds, professional managers with bundle of the money, and the individuals that make investments which seeks to profit from the volatility of the market. VIX is an implied volatility in the parlance of the industry of the securities. It is equally similar to the bonds which provide the yield at the time of the maturity.  The VIX is often referred to as the “investor fear gauge” (Whaley, 2000). Generally when the stock prices are falling and investors are having a fear the volatility and the index move up accordingly. Like a bond a stock option has a model for its valuation and also the number of parameters are engaged which are to be estimated with high level of accuracy. To find out the implied volatility the market price of the index option is equated with model value.  This implied volatility is therefore the best benchmark of the expected volatility of the underlying stock over the remaining life of the option. Since VIX is based on S&P 100 index option prices, VIX represents a market consensus of the S&P 100 with expected volatility.

When the transactions of the stock option began in the year 1973, Chicago Board Options Exchange has made sure that the market volatility index can be constructed by the option price which can reflect the expectation of the future.  Since the initiation many methodologies were proposed by different scholars. Then and there Whaley proposed a simple approach which typically deals with the evolution of the market volatility index and making the same as the measure of the future stock market price. In the similar year, the Chicago Board Option Exchange started to figure out the development of the CBOE volatility index also commonly known as VIX. The VIX is based on the implied volatility of the S&P 100 index options. After the ten years of its inception the VIX was accepted by the stock market. From thereafter many indexes are calculated by the CBOE including the NASDAQ 100 index, in 2003 VIX based on S&P 500 index, which is much nearer to the actual stock value. CBOE Russell 2000, CBOE DJIA volatility index and RVX in India the VIX came into existence in April 2008 by national stock exchange and is based on Nifty 50 index option prices (Stanton, 2011).

Calculation of the VIX

The original index was based on the option prices of S&P 100 index rather than the S&P 500 index. At the time, OEX options were widely traded options in the United States which was covering about the 75% of the total volume of the index option in the year 1992 whereas in case of the SPX option it was having a coverage of 16.1% of the volume. The implied volatility index of the VIX is based on the prices from a deep and active index option (Whaley, 2009).

The second feature of the original VIX was that only eight money index calls and puts. This seems to be reasonable because of the option series available at the time and the money options were traded actively. On the other hand the options which were having less exercise prices were not traded that actively. Such quotations if have been included in the calculation of the VIX it have reduced the timeliness and the accuracy. Since its evolution a change has been observed fundamentally.

Normally there is a formula for VIX calculation given by CBOE to derive at the volatility. Under this the average is calculated on the basis of the money puts and calls. A put is an option contract which gives right to the owners to see the underlying asset at a specific price and a specific time. There is a belief in the mind of the buyer that the price will fall below the exercise price before the expiry date. On the other hand the call is an option contract which gives the right to the owners, but not the entire obligation to purchase a particular amount of the asset at a specified price within a specified time. A call auction can also be referred to as the call market (Whaley, 2013).

The money calls from the SPX and money puts form the SPX are cumulatively centred together at the strike price of the money, determined by the K0. Only those options are included in the calculation of the VIX index calculation which is of non-zero nature. Here the important note that is to be taken care of or shall be considered is that as the volatility escalates and falls down there is an expansion of the non-zero bids tends to expand and contract eventually. Therefore the frequency of the variation is high as the number of options may vary either on monthly, daily or minute to minute basis. Henceforth, the right selection is important (Cboe volatility index, 2018).

Importance of the VIX for financial markets

Here under the contract month option, the forward SPX hall be determined and indicate it by the alphabet F, by identifying the strike price to calculate the smallest absolute difference between the call and the put prices.

Near term options

Next term options

Strike Price

Call

Put

Difference

Strike Price

Call

Put

Difference

1950

37.45

15.25

22.2

1950

41.05

18.9

22.15

1955

27.32

16.8

10.52

1955

36.45

20.21

16.24

1960

34.89

18.32

16.57

1960

33.05

21.3

11.75

1965

21.05

23.15

-2.1

1965

27.3

24.9

2.4

1970

26.85

25.33

1.52

1970

24.13

26.35

-2.22

1975

18.1

19.72

-1.62

1975

21.1

31.05

-9.95

1980

15.32

16.55

-1.23

1980

18.3

33.05

-14.75

Calculate volatility for both near term and next term option in which a simple calculation is performed for each option.

The CBOE volatility index is useful in measuring the expected volatility of the S&P 500 over a three day target time frame. In order to calculate the measure the Chicago Board options Exchange observes the price behaviour of many different call options and put options on the index of S&P 500 with the help of different strike price and multiple expiration date that are known for the incorporation of the trading and the weekly options.  Also the BCOE takes a weighted average to calculate the index of the value. The major reason for why it is important for the financial markets is to record the actual price. The tendency of the VIX is inversed with respect to the situations of market (Oltarsh, 2016). As the market drops the VIX rises and vice versa. The VIX also used by the traders of the market to interpret the danger points and its levels in determining the stock price. Once the VIX has accelerated there might be some shares whose prices might have fallen already. The usefulness of the VIX increases when the stocks are seen at a cumulative level. The volatility for the individual stocks can differ from the stocks involved in the broad range category. To get a sense and mood of the market the VIX becomes important to option traders as well as ordinary traders.  For example due to keeping a record and updates of the VIX index the founder of the Motley fool and his brother Tom Gardner together have tripled the value of the stock market in last thirteen years. The choices of the stock they carry in their portfolio itself showed the importance of tracking down the VIX.

(Source: Online Trading Academy, 2016)

VIX or the related products of the VIX can be used for the management of risk in the following manner. Therefore, the risk management is the key focus in the designing the VIX strategies.

Most of the strategies seek to harvest the volatility-risk-premium in the VIX futures which ultimately provides the long term edge.  At times, the VRP may vary and can be positive, negative, or neutral. The performance is generally determined by the direction of the VRP which provides some clues and hints. This way the volatility risk premiums is in the favour of the investor and it can be used it mitigate the risk by keeping a track through the use of the directions. The positions can be adjusted by determining the relationships between the VRP, VIX futures, Spot VIX and the volatility of the S&P 500 to eliminate the risk and gain the potential advantage in the long run (Anson and Ho, 2003).

No one can predict the future, and it becomes cumbersome when the investors play the puzzle to understand the direction of the volatility and usually risky one. Instead of trying to predict the movements of the volatile nature and it is advised to take a reactive approach in which the investors are supposed to react according to the volatility of the stock. A response can be observed with regard to the changes in the VRP and this way it can help in minimising the risk (Bhansali and Harris, 2018).

Conventionally a simple scaling in/out strategy is greatly outperforming the XIV drawdown buy approach. This scaling strategy is not advisable for the investors who are thinking to make the movement in the investments over the night. Therefore, one way to reduce the risk is to stop the overnight exposures as it literally increases the trading costs and fails to capture any favourable movements overnight (Lee, Liao and Tung, 2017).

The volatility risk premium is important and equally valid in case of the size of the strategy volatility exposure. If the VRP is large and if it seems to be in the favour of the investor, the investor with the help of such strategy can increase the exposure and when the premium skews the investor may reduce the exposure. This provides the risk adjusted exposure to the VRP and most of the risk is taken when the probability of the event is positive.

Not every VIX strategies are exposed to the similar risks and each set of risk has its own strength and weaknesses. Not all VIX procedures are presented to similar dangers, and every set of the risks has its own strengths and weaknesses. These differences can significantly traverse the performances due to market conditions. Diversifying the portfolio will reduce the risks of the stock and will also give the opportunity to the investors to shift the risk from one stock to another (Miao, Ramchander, Wang and Yang, 2017).

Volatility trading strategies can generate the returns on timely basis. A strategy is designed to get the benefits from the stock for long term purposes and to avoid any kind of risk that can shake the drawdown scenario. While these strategies help in reducing the risk and the magnitude of the duration of the drawdowns (Bekaert and Hoerova, 2014). 

The introduction of the Exchange traded volatility products also known as the ETP’s VIX future contracts were launched in the year 2004, listed VIX option in the year 2006 and volatility ETP’s in 2009 facilitates a lot of opportunities  and enables the investors to access the class of the assets and strategies that were out of reach earlier (Buehler and Cusatis, 2018). The facilitation of the short term volatility trading by traders at the short horizon end gives a magnitude to the investors. One such example is the volatility space, which has been changed from a hypothetical but however, a broadly followed measure of financial sentiment of the investor. The VIX, which measures the suggested unpredictability of U.S. equity markets over a period of 30 days and is computed on the basis of S&P 500 has been around for over two decades, yet by the difference of idea its estimation is not an investable resource (Rhoads, 2018).

VIX ETP’s can be useful to hedge or cover the investments or to speculate on sell off of potential nature. Generally VIX ETF’s are available for trading through the help of a range of brokers. The largest and most popular volatility ETN is S&P 500 VIX Short-Term Futures Exchange Traded Note. Generally VIX products and the related ETF’s are useful in management of the risk. The first big accomplishment of the VIX ETPs was in the year 2010. There are certain ETP’s such as SPDR S&P 500 ETF Trust, ishares Core U.S. Aggregate Bond ETF iPath Pure Beta Cocoa ETN and Rex VoLMAXX long VIX futures Strategy ETF. Keeping a view of the performance of these ETP’s in the financial market both the strategies allow the traders to participate for the expected returns. During the year 2017, the performance of the ETP’s was outperforming.  The stellar performers in the bucket 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%. 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 top performers are as follows.

(Source: CBOE, 2018)

Apart from the 10 VIX products, many of the ETP’s are related to the commodities. The Ipath Bloomberg Cocoa Sub index Total Return ETN (NIB) and the Iptah Pure Beta CocOA ETN is categorised under the commodity pack. The gains were received at the rate of the 33% each. The performance of the VelocityShares 3X Long Crude Oil ETN (UWT) has also been more than par. All in all the performance of the ETP’s has shaped the stock market and rebalanced the products. Recent estimates were credible and the assets were in the volatile market continued to grow (Chang, Hsieh and McAleer, 2017).

A statistical measure of the dispersion of returns for the available market security or index is termed as volatility. The volatility is normally measured with the help of the standard deviation or variance through the use of same security or market index. In simpler sense volatility can be referred to the uncertainty or risk with respect to the change in the size of the security. The short term volatility is an active strategy in which the put options are rolled to maintain a continuous hedge against the merger arbitrations and strategies driven by the events. Also a change is observed in the amount of the put as the delta of the short put changes. Strategies are basically designed on the basis of the market (Beuhler, 2016). On the other hand the short volatility is apparently considered a synthetic and off-balance sheet in nature.

There are many ways to create the returns through the short term volatile strategies. One of the strategies is hedging which is an advanced form of investing. In simper terms the investors use the hedging strategy by hedging one investment by making another (Jadhao and Chandra, 2017).

Technically two stocks with negative correlation are used. However, there are certain option strategies which are as follows.

Short selling is also known as “Shorting” or “going short”. Under this activity the sale of the security that has been borrowed by the seller to make the short sale. In this scenario the seller assumes the prices of the securities will fall and hence it can be bought back at a diminished price. The profit is determined by the variance in the prices of the purchase and sell. Short selling strategy is used to determine the functioning of the market(Engelberg, Reed and Ringgenberg, 2018). Due to investments in the short term volatile strategies the market performs smoothly by providing the liquidity and also serves as restricting the influence on investors. Short selling also acts as a reality check which is highly useful in preventing the stocks from being bid up to the escalated heights (Har?ariková and Šoltés, 2017). While shorting is conventionally a risky activity since it goes against the long term upward path of the market.

This strategy offers the convenience to the trades in which a small sum or margin is required to be paid against the total sum up front to execute the transaction. The major advantage of this strategy is to the cost of the transactions is overall low and the brokerage is not charged high. Hence, it is useful in making the returns. After identification of the potential gains and the risks involved, investment is made. On one side the stock is purchased and on the other side the derivatives which have been already purchased were sold out as call options to avail the benefit of the profit. This way the returns can be earned subsequently (Options Trading. Org 2018).

The positive movements in stock will also come up with the results of premiums earned constantly by merger arbitration and event driven hedge funds. This type of return pattern is aligned with a short put option exposure (Fidelity, 2018).

(Source: Berman, 2017)

A regression line is plotted to find out the excess return to event driven hedge-funds to the S&P 100. A kink has been observed I the fitted regression line and it is kinked around a return of 0% in excess. The kink particularly defines the regression which indicates the two valuable relationships among the excess returns and S&P 100 and excess returns driven by hedge funds (Cui, Feng and MacKay, 2017). Event driven hedge funds earn a consistent return regardless of the positivity of the market and its performance.

There are certain short term volatile strategies which creates risks for the fund managers and the financial markets. One of the basic risks is the difference between the spot price and the future price. The risks arise generally due to the uncertainty of the basis when the hedge is closed out (McKellar, 2017).

When compared to the long position in a security and where the amount which is invested is typically not driven by huge losses and the profits are in abundance a short sale is worthy yet prone to a risk. The risk is of the infinite loss is analysed when the gain is highest and the value of the stock drops to zero (Pfund and Fowler, 2017).

There are times when the investors stand opposite to the sentiments of the markets and create own sentiments. For example the investor has a sentiment, that the price of the stocks is going to fall and the rest of the market thinks opposite of the idea. This strategy is known as opposite sentiments strategy. The highest risk that is involved in this the idea or thought of the price to be less against the thought of the market can be probably opposite and the stock may fail for the investor (Chen, Lee and Hsu, 2017).

Generally the investors follow the trend and on the basis of that the investment is made. Just by looking at the trend that has been developing year by year the investors estimates the returns that can be driven from the stock and an investment is made, whereas in particular the investors are not going for a fundamental and deep analysis. Eventually there is a high risk associated with the stocks under the short volatility market. At times just on the basis of the fluctuations in the price of derivatives and the previous trends the investments had been purchased in the financial market. However, just on the basis of the trends a decision cannot be taken and there are high chances of risk (Hudson, 2017).

Once there is a change in the government policy or the economic reform the impact of the same is reflected over the stock market immediately. Therefore, this is also one of the risks which can change the trend of the existing stock market under the volatile situations.

The risks presented above do have a cover to protect against the future risks. There are certain measurements which can eliminate the risk to a certain extent. One of the ways that can be adopted is to buy put options on the index of the VIX and which is equivalent to the exposure driven by the short volatility associated with the event driven and the merger arbitrage strategies (Strong and Jeyasreedharan, 2017). This is an active strategy under which the amounts of the options are rolled out. Additionally, there will be change in the purchase value of the put options. This is also known as the portfolio insurance.

The another solution is to invest the amount in the hedge fund strategies which are of long volatile in nature such as managed futures or commodity trading advisors. To follow the trend driven strategy lets the mangers and the investors in the financial markets to capture the essence of the prices which are exceptionally extended upside and downside. The other traders also buy volatility to hedge the portfolio risks (Options Trading. Org 2018).

The risk parity option or strategy can also be the one strategy which is used to subsidise the risks. This strategy helps in equalisation of the risk contribution across the portfolio assets by increasing the level of the low volatile assets. The volatility is not sold rather there are certain decisions in the portfolio which are driven by a cluster of decisions generally depends upon the estimations. The decisions are sensitive to the changes in volatility and the behaviour is implies towards the short volatility (Neuberg and Glasserman, 2017).

Under the hierarchy of the risk the next solution to minimise the risk is to examine the trend and records over the intervals the management of the stock and the assets. Generally the managers attract the funds and deliver the alpha performance and to augment the returns they sell the volatility. The inclusion of derivatives and the and out of index securities facilitates the decrease of the risks. The best way to deal with the volatility is to sell the high beta stocks and replace them with lower beta names (Fan, Xiao and Zhou, 2018).

Risk premium strategies are widespread strategies which are inclusive of certain models that can cover the risks or minimise it. In wide terms the risk premium funds are generally adopted to transfer the risks and derive profits from the same. The earnings are from the term premiums. Risk premium strategies vary in nature and some of the strategies include the momentum and few of them uses the tail hedges (Chen and Lien, 2017).

References

Anson, M. and Ho, H. (2003), Short Volatility Strategies: Identification, Measurement, and Risk Management, Journal of Investment Management, 1(2), pp. 30–43.

Bekaert, G. and Hoerova, M., (2014) The VIX, the variance premium and stock market volatility. Journal of Econometrics, 183(2), pp.181-192.

Berman. N (2017) Event-Driven-Equity Hedge fund crowding overshadows positive fundamental backdrop [online] Available from https://www.nasdaq.com/article/event-driven-equity-hedge-fund-crowding-overshadows-positive-fundamental-backdrop-cm626413 [Accessed 21st June 2018].

Beuhler, N. (2016) Strategies to control risk in volatility trading [online]. Available from https://seekingalpha.com/article/3958250-strategies-control-risk-volatility-trading [Accessed 20th June 2018].

Bhansali, V. and Harris, L. (2018), Everybody’s Doing It: Short Volatility Strategies and Shadow Financial Insurers, Financial Analysts Journal, 74(2), pp. 12–23.

Buehler, D.L. and Cusatis, P.J., (2018) Trading the VIX Futures Roll Using Exchange-Traded Funds. The Journal of Trading, 13(2), pp.47-56.

Cboe volatility index, (2018) Calculation of the VIX, [online]. Available from https://www.cboe.com/micro/vix/vixwhite.pdf [Accessed 21st June 2018].

Chang, C.L., Hsieh, T.L. and McAleer, M., (2017) Connecting VIX and Stock Index ETF (No. 2016-010/III).

Chen, H.K. and Lien, C.T., 2017. Market Reaction to Macroeconomic News: The Role of Investor Sentiment. Asia?Pacific Journal of Financial Studies, 46(6), pp.853-875.

Chen, M.P., Lee, C.C. and Hsu, Y.C., (2018) Investor sentiment and country exchange traded funds: Does economic freedom matter?. The North American Journal of Economics and Finance, 42, pp.285-299.

Cui, Z., Feng, R. and MacKay, A., (2017) Variable annuities with VIX-linked fee structure under a Heston-type stochastic volatility model. North American Actuarial Journal, 21(3), pp.458-483.

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