Stuart Barton I Original Publication: May 24, 2017 I Last Updated: January 20, 2021
Summary
Some VIX Exchange Traded Products ("ETPs") benefit from ‘Roll Yield’
'Roll Yield’ or 'Volatility Risk Premium' of the futures relies on a sloped term structure
I explain why this structure exists and how it may change
Despite the delisting and de-leveraging of some of the most popular VIX-linked ETPs, interest in the space remains unsurprisingly high. As of January 20, 2021, the three most popular VIX-linked ETPs (Tickers: VXX, UVXY, and SVXY) amounted to $3.36bn in AUM. [1]
A great deal of interest in these ETPs stems from two simple observations: 1) that equity market volatility - and hence the value of the VIX Index - is frequently mean reverting, and 2) that the VIX futures curve is frequently upward-sloping. These observations are often cited to explain why inverse VIX ETPs have received a daily accrual, and why long VIX ETPs pay a decay. But why is this the case, and is it reasonable to expect that these conditions will persist?
To answer these questions, let's first remember what underlies the ETPs themselves. VIX ETPs track or trade the VIX futures and not the VIX Index itself, and the performance of the futures frequently differs from the performance of the index. Just like futures on other indexes and underlyings (e.g. oil), VIX futures only converge to the index value at their expiry, but they can trade at significantly different values before then. It is this daily change in futures prices and their eventual convergence with the Index that brings about the decay or accrual observed in VIX ETPs.
But why does an upward-sloping VIX futures curve exist, and how are VIX futures priced? I will try and explain what's going on behind the scenes.
At any given time, the price of the VIX Index is calculated from the implied volatility of a series of S&P 500 options trading at the CBOE. For the details of this calculation, I point you to the CBOE's VIX site, but suffice it to say that while this calculation is rigorous and robust, it is somewhat tedious to complete. [2] However, while the cash value for the VIX Index can be calculated with some certainty, the value of a future can be more subjective.
VIX futures are priced from the value of a forward-starting 30-day variance contract beginning on the settlement date of each future. That is to say, the price of the VIX future is determined from the portfolio of S&P 500 options that will make up the VIX Index at the future's expiry. And this is where things get tricky. Because it is impossible to know where the value of the S&P 500 will be when the VIX future finally expires, it is impossible to know ahead of time which S&P 500 options the future will ultimately reference. Furthermore, it is impossible for VIX futures dealers to know with certainty which options to use as a hedge against their future's position.
This unknown element in VIX futures' pricing is sometimes referred to as 'convexity' or 'concavity' and accounts for the cost associated with hedging the unknown path of the S&P 500 ahead of a future's expiry. To the dealer, this is expressed as the yet-to-be-determined costs of continuously adjusting the required options portfolio between trade date and the ultimate expiry of the future. If the S&P 500 moves considerably before the future expires, hedges will have to be adjusted, and the frequency and magnitude of these adjustments can result in significant costs.
Imagine the situation of needing to buy S&P 500 options as volatility rises and then sell them back as volatility falls. Dealers call these effects 'volatility of volatility' - and understand they are not simple to hedge or predict.
So how does this lack of a risk-free hedge contribute to an upward-sloping futures curve? Well, because the ultimate cost of a VIX futures hedge is unknown, and because the VIX Index tends to rise far more quickly than it falls, the market tends to sell futures above the average historical settlement level. Like an insurance premium, sellers take on the risk of an increasingly volatile market and the future settling at considerably higher levels for an upfront price premium.
This premium is sometimes referred to as the 'Volatility Risk Premium' of the future, or VRP for short. [3] The longer dated a futures contract is, the greater risk of an unforeseeable event moving the S&P 500 considerably, and as a result, the greater this premium.
But if this is the case, why does the VIX futures curve so frequently invert? Actually, for very similar reasons. After a significant move in the S&P 500, the price of options typically rises in response to the increased uncertainty, and as these options increase in value, so does the level of the VIX Index that references them. For short-dated VIX futures - with little time to expiry - this move in the VIX Index can quickly translate into a futures price increase, as expectations of the future's coming settlement value rises. [4]
Meanwhile, longer-dated futures can react quite differently, with their price tending to follow average historical VIX settlement levels plus a VRPF. While the VRPF may increase, short-term market events tend not to raise long-term expectations of average settlement levels.
So while an upward-sloping VIX futures curve is common, small increases in the volatility of the S&P 500 can quickly cause it to invert. During an inversion event, not only are inverse VIX ETPs likely to lose value, but they may also lose the daily accrual they benefited from during an upward sloping futures curve - suddenly paying a daily decay rather than receiving an accrual. This 'double whammy' of capital drawdown followed by a daily decay may pressure owners to cut losses at very inopportune movements.
Furthermore, the relative severity of a curve inversion during periods of extremely low volatility may be considerably higher. For example, a sudden move down of say 4% in the S&P 500 would translate to a one-day realized volatility of more than 60%, a move that would likely elevate the future volatility implied by the VIX Index. A move like that would no doubt significantly increase the price of short-dated VIX futures as well for the reasons explained above, while longer-dated futures may be affected considerably less.
If this were to happen, not only would inverse VIX ETPs lose considerable market value, but the resulting daily decay may be more than many investors are willing to endure, making historical gains difficult to repeat. Returns have of course never been free.
This article was originally published on Seeking Alpha. For more Seeking Alpha articles by Stuart click here.
[1] Source: ETF.com
[2] The CBOE Volatility Index. Available here.
[3] Cooper, T. (2013). Easy Volatility Investing. Available here.
[4] Empirical CBOE research demonstrates this relationship well. CBOE, 2016, available here.
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