Volatility Exposure Using Listed Futures

January 23, 2009

A background on the construction, replicability and characteristics of the S&P 500 VIX Short-Term Futures Index.


Volatility, or the second moment of the price distribution of an asset, has emerged as an important asset class in the last decade.

It is actively traded through over-the counter (OTC) variance and volatility swaps, and through exchange listed VIX futures and options. While VIX has achieved widespread recognition, it remains very challenging to replicate spot VIX.

The S&P 500 VIX Short-Term Futures Index is the first index to offer directional exposure to volatility through publicly traded futures markets. This paper provides a background on the construction, replicability and characteristics of this index.


A Brief History Of VIX

Since Black-Scholes and similar option pricing models came into widespread use after 1973, market participants have had access to tools that provide a framework for pricing options once expected volatility has been forecast. By repeatedly adding educated guesses as to implied volatility into the formula, implied volatility can be calculated, given a known option price.

In 1993, The Chicago Board Options Exchange introduced VIX, which combined implied volatility calculated via the Black-Scholes model for a range of at-the-money S&P 100 options strikes. The resulting index provided a minute-by-minute calculation of implied 30-day volatility, and rapidly became the premier indicator of US stock market volatility. Analysis of volatility showed that it hits its highest level during periods of market turbulence; hence VIX gained the moniker "the investor fear gauge."

Changes in theory and in market practice led to a suite of methodology changes in September 2003 that further improved the usefulness of VIX. Since the S&P 500 is the more widely-followed indicator, it replaced the S&P 100 as the index underlying the options used for VIX calculation. Equally importantly, the calculation method was changed, replacing Black-Scholes with a more practical method used in the variance swap market, independent of any particular pricing model. This simplified the methodology as well as making it more useful. The calculation also uses a broader range of strike prices, rather than just at-the-money strikes, although it gives a lower weighting to strikes further from the money. The changes increased the practical appeal of VIX and allowed VIX to be replicated, in theory, using underlying options. Futures and options on VIX were launched in March of 2004 and February of 2006 respectively. In practice, however, VIX remains difficult to trade or replicate because the underlying basket of options is large and constantly rebalanced. However, volumes and open interest for both VIX futures and VIX options have increased dramatically since their launch, as shown in Exhibit 1.


Exhibit 1: Volume & Open Interest for VIX Futures


The S&P 500 VIX Futures Index Series

Futures based indices have proven to be valuable tools to access exposure to alternative assets with limited liquidity in the spot market. The advent of the VIX futures market provided an opportunity to extend this concept to the volatility market. The S&P 500 VIX Futures Index Series includes two indices, the S&P 500 VIX Short-Term Futures Index and the S&P 500 VIX Mid-Term Futures Index. This document focuses on the former.

The S&P 500 VIX Short-Term Futures Index is comprised of the first nearby and second nearby VIX futures contracts, which are rebalanced daily in equal increments to maintain a constant one month maturity. The index has an excess return version which is comprised solely of futures price returns, and a total return version which includes the reinvestment of risk free returns. The index is calculated in a similar way to the S&P GSCI, the leading futures based index.1

A key feature of the index is replicability. While spot VIX is difficult to replicate, the index can be easily replicated via exchange listed VIX futures contracts using the index's simple, publicly available methodology. The constant one month maturity also presents opportunities to indirectly replicate the index via OTC volatility swaps, which are well established in the institutional market.


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