Stuart Barton, PhD, CFA I January 29, 2019

Following a recent RIA Channel Webinar we presented with VelocityShares, we received a series of questions that reminded us of the many facets of volatility trading that people feel far from comfortable with. Beyond the simpler questions, like whether or not the VIX is an investable index (it is of course not), there seemed to be a general misunderstanding of where the returns in popular VIX linked Exchange Traded Products (ETPs) like SVXY and ZIV come from. This misunderstanding seems to stem from a confusion of terms like contango, roll yield, Volatility Risk Premium (VRP), and Futures Risk Premium (FRP). This article will try and explain the source of these returns by more clearly describing the difference between VRP and FRP.

In a characteristically well written article, Vance Harwood has already approached a related misunderstanding before, and I recommend reading his article ‘__The Cost of Contango: Not the Daily Roll__’ to help better understand how the shape of the VIX futures term structure effects the price of popular ETPs. He explains how these products ‘roll futures’, and that this roll does not affect their returns, but instead their returns frequently arise from the inevitable changes in value of the VIX futures themselves – a change in value that could be better described as ‘contango decay’ than ‘roll yield’.

‘Contango decay’ can be thought of as the steady decline of VIX futures prices towards the value of the VIX Index - or as some would argue – the pull of the VIX Index towards the VIX futures. I won’t go into the arguments for and against either interpretation, but suffice it to say the first argument relies on the relationship between traditional investable commodities and their futures and ignores the ‘uninvestability’ of the VIX Index, while the latter relies on the Vega weights of the portfolio of options that the VIX Index references compared with the portfolio that the futures reference. It’s important to remember that the VIX Index has the only futures underlying that is totally uninvestable and this facet alone gives the behavior of its futures some surprising characteristics.

So what is this contango decay and is it the same as VRP? Well simply put, no! Contango decay is a characteristic of futures prices while VRP is a characteristic of options markets – including options on the S&P 500. It’s perhaps helpful to think how there’s contango decay in oil futures that no one would ever describe as VRP. The confusion of these two terms can cause investors to make poor decisions when investing in VIX ETPs, and properly understanding the difference can help investors better utilize these products.

In contrast to FRP, VRP is the premium paid by option buyers to insure their portfolios. Often quoted in terms of volatility points, it is the difference between implied volatility (the price of options in volatility terms) and realized volatility (the volatility an investor actually experiences). This premium is frequently positive, i.e investors frequently pay several vol points more for options than the volatility they realize. For option buyers this is the cost of insurance, for option sellers this is VRP.

So VRP is an options market phenomenon, the outcome of option buyers willing to pay away a premium to hold a hedge or insurance over their portfolios. Priced in vol points, this premium does find its way into the VIX futures market but not as FRP as some assume.

By way of explanation it is useful to take a step back. The VIX Index is one measure of implied volatility, and represents the average implied volatility of a portfolio of options expiring in 30 days’ time. As a measure of implied volatility, the VIX Index is a useful way of gauging the price (in volatility terms) that investors are willing to pay to own portfolio insurance over the next 30 days. It is also a useful tool to estimate VRP.

A good estimate of historic VRP can be made by subtracting historical realized volatility from that implied by the VIX index. For example, if the previous 30 days have demonstrated an annualised volatility of just 10 volatility points, and the VIX Index was valued at 20 just 30 days ago, one could describe the 30 day historic VRP as 10 annualized vol points (20 implied – 10 realised). If the VIX remains unchanged and over the following 30 days the SPX actually realizes 15 vol points, one could describe the realized VRP as 5 (20 implied – 15 realized).

This VRP is traded actively in the S&P 500 options market through the daily gamma-theta relationship of options and the daily moves in the index. If daily moves exceed expectations, gamma gains on delta hedged option portfolios will exceed theta loses and visa versa. If traders expect realized volatility to rise they may be willing to pay more for options and visa versa.

So how does this relate to the VIX futures market? Well, VIX futures represent the market’s expectation of the level of the VIX at that futures’ expiry i.e it is the market’s expectation of 30 day implied volatility sometime in the future. If expectations rise over time, so will the price of the futures and visa versa. This change in VIX futures prices is therefore the direct result of a change in expectations and frequently not the result of historic or realized volatility.

So if a VIX futures’ value falls from say 15 to 10 over a month this is because the expected value of the VIX (the implied volatility of the S&P 500) has fallen and does not necessarily mean realized volatility has changed one way or another. This might occur for example if an upcoming market event results is an underwhelming response, that is to say as the event passes so does the expectation of future volatility, and this can occur with or without a realized volatility event.

So why are longer dated expectations of volatility so frequently higher than shorter dated expectations, i.e why are VIX futures so frequently priced higher than the VIX index itself? Well this relates to the shape of the S&P 500 options term structure, or the term structure of implied S&P 500 volatility.

The underlying market for most US equity volatility products is the S&P 500 Index, and it is demand for options and structured products linked to the S&P 500 that ultimately dictates the shape of that implied volatility curve. There are numerous products driving this shape as well as complex technical effects like interest rates on forward volatility, but two of the simplest influences are leverage and portfolio insurance, and demand for both of these play important roles in defining the shape of implied volatility curves.

Portfolio insurance is perhaps the most spoken about source of demand for options. Put simply, demand for portfolio insurance results from managers buying puts on stocks or their indexes to help protect their portfolios from downward moves. Their continued buying of puts and rolling these puts further and further out in time maintains a steady upward pressure on longer dated implied volatility.

The second, equally important influence but often overlooked, is the demand for leverage. Buying unhedged options can give fund managers tremendous exposure to the market, while at the same time only risking the cost of their premium. This useful characteristic of options, coupled with the immense scale of the long only equity market creates a further demand for longer dated options and an upward pressure on implied volatility. The same applies for structured equity products issued by banks and insurance companies. Given the leverage available in options, structured products typically utilize options to take their long term equity exposure, thereby leaving more free cash to utilize on other exposures or to simply fund other areas of the bank.

So these are some of the reasons for an upward sloping S&P 500 implied volatility curve. But how does this upward sloping S&P 500 curve transpose to an upward sloping VIX futures curve? Well, it’s useful to remember that the VIX Index and its futures are ultimately a reflection of S&P 500 implied volatility, and, as such, longer dated VIX futures are a reflection of longer dated S&P 500 implied volatility. A steep S&P 500 vol curve therefore frequently results in a steep VIX futures curve. Those of you who have read my earlier articles will know that this relationship is far from perfect as there is no true ‘arbitrage’ opportunity between VIX futures and SPX options, but despite this there are numerous proxy hedges that make this relationship strong.

So that explains why the VIX futures curve is frequently upward sloping and why a VIX FRP exists - longer dated VIX futures are priced higher because of a consistent demand for longer dated S&P 500 volatility products. But how is FRP realized in VIX linked ETPs. Well, simply through the passing of time. If 90 day VIX futures are priced at 20 vol points, and 60 day at just 15 then - all else being equal - those 90 day futures could be expected to decay to become 60 day futures in just 30 days – a decay of 5 vol points in 30 days or about 17bp of vol per day. Inverse VIX ETPs that track the inverse value of these futures would therefore benefit from these decaying futures, and as you’ll now see can have little to do with the difference between implied and realized volatility of the S&P 500.

So why is it important to understand the difference between VRP and FRP? Well, FRP can exist whether VRP exists or not, or put another way, FRP and the corresponding decay in VIX linked ETPs, can exist whether or not implied S&P 500 volatility exceeds realized or not, and keeping an eye on FRP may be more important than VRP when choosing to buy or sell a VIX linked ETP.

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