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Beware of hidden costs in Vix-hedge no-brainer
by James Phillipps on Mar 29, 2012 at 10:31
Concerns around the eurozone sovereign debt crisis and the risks to the financial sector have sent the cost of hedging soaring.
Although the short-term CBOE Volatility index (Vix), the most commonly used proxy for volatility, is at 14.85, below its historic average of around 20, the volatility futures curve has moved close to record levels.
So, while on the face of it, owning the Vix at under 15 seems a no-brainer given the risks hanging over the market, last Wednesday’s close marked the third steepest contango reading for front and second month Vix futures ever. Therefore investors wishing to use Vix futures as a hedge for their portfolios face massive roll costs to maintain this protection when their first month futures expire.
One analyst, who preferred to remain anonymous, said: ‘Historically, 95% of options expire worthless and Vix futures strategies are not a means of beating the odds – there is no arbitrage.’
Several alternative ways to play the Vix are also fraught with problems. A number of exchange traded funds and products have been launched in recent years that attempt to track the Vix, but the issue of roll yield has seen their performance at times be wildly uncorrelated to the underlying index.
Barclays Capital has this week launched a product, the S&P 500 Dynamic Vix Futures Index Total Return, which is structured as a delta one note.
The firm’s Lisa Chaudhuri said the product aims to reduce the impact of the cost of roll by moving between short and medium-term Vix futures depending on whether the market is in contango or backwardation. ‘What you find is that the cost of carry on the short-term Vix is very high and on average this costs around 8%,’ she said.
‘Private clients have been wary of buying volatility due to concerns that they lose a lot of money on this roll cost if volatility doesn’t rise to offset this. What we are trying to do is come up with the second generation of volatility products following on from ETFs and ETNs, which focus on only one part of the curve.’
The note uses an automated strategy looking to benefit from the shape of the volatility curve, which has historically been indicative of the future direction of the Vix.
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