What to Make of the Latest Volatility Gauge

The CBOE launches a new volatility product to hedge interest rate volatility risk

by Adam Warner

Published on Nov 12, 2014 at 9:05 AM
Updated on Apr 20, 2015 at 5:10 PM

We've had the ability to publicly trade volatility directly for about a decade now. First came CBOE Volatility Index (VIX) futures. Then came VIX options. And so on and so forth to now, where we have hundreds of vehicles. It's become an unquestioned success, as interest and volume are booming, most especially in VIX futures and options themselves. Much of that surge is thanks to non-equity players using VIX as a general hedge. Credit players are now thought to be the biggest players in VIX products. But, there's some debate as to how well VIX works as a credit portfolio hedge.

For example, this J.P. Morgan Securities paper loves the idea. On the other hand, this academic paper does not:

"The conclusion that hedging credit risk in the equity markets is relatively ineffective is robust across sub-samples of firms of different rating classes as well as across sub-periods."

Well, good news! The Chicago Board Options Exchange (CBOE) is listing a new product that should please everyone.

"Futures trading on the CBOE/CBOT 10-year U.S. Treasury Note Volatility Index (VXTYN) is scheduled to launch on Thursday, November 13. Futures on the VXTYN Index will offer customers a way to hedge pure interest rate volatility risk based on U.S. government debt with a single product for the first time."

They run through a bunch of tables and numbers that suggest this index aligns well as a credit hedge. And they chime in on the debate about VIX, as well:

"While some investors may have the impression that volatility indexes tend to move very closely together, note that the correlation of VXTYN and the CBOE Volatility Index (VIX®) in the above table is only 0.21, and each index has had unique price movements."

Now, new products don't get hugely popular from day one. I mean, sometimes you see big volume, but it's often some locals "augmenting" the tape. Players using VIX as a credit portfolio hedge won't instantly switch to VXTYN. They'll need to make sure there's enough liquidity to get in and out without much slippage. But, if VXTYN does catch on, does that come at the expense of the overall VIX complex? It's difficult to tell. No one knows exactly how much volume in VIX is thanks to credit hedgers. You don't fill out a form with your hedging/speculating intentions every time you make a trade.

Deep markets are always the key. We know VIX has them now, and that's what makes it such a great product. But, if that starts to dry up, it could become a problem. The lion's share of VIX options flow involves the "public" buying upside VIX calls as either straight purchases or ratio spreads. That's a tough trade for a market maker to hedge, so you really need a deep futures and exchange-traded note (ETN) market to make it all work. VXTYN will clearly add to volume/liquidity overall, but at 0.21 correlation, it's not going to provide a desirable hedge against VIX trades.

Adding more and more products hasn't tamped overall liquidity so far -- in fact, it's certainly helped. So, let's hope that trend stays in place.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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