Vol Derivatives: Robust Benefits for European Equities Portfolios

Derivatives 02 Jul 2012

Two scholars with the EDHEC-Risk Institute have offered an analysis of the benefits of volatility derivatives in portfolio management from the point of view of Europe’s equity investors.

As you can see from the graph below, there is a negative correlation between the Euro Stoxx 50 index on the one hand, and a measure of its expected volatility, based on options prices, on the other. Thus, on the left hand side of the graph, the prices of the European stocks measured in this index (the blue line) were sharing in the late 1990s boom, on the way up. Expected volatility (the red line) was moving down as the 1990s ended, and then stayed down – moving sideways if you will, right into the recession of 2001 (the first dark band on the graph).

Volatility spiked upward at the end of that dark band, and this was at a time when the bear market in these stocks still had a ways to run.

The pattern continued. When the blue line headed up, the red was heading down, and vice versa, right into 2011. During the two dark-banded recessionary periods, the negative correlation between the red and blue lines is especially pronounced, reaching -0.78.

A 5-year rolling window of correlations between these two values, for the period from January 1999 through April 2006, is consistently above -0.6 and almost always above -0.7, though usually below -0.8.  By any standards, that amounts to a very impressive negative correlation: just what one wants in creating a hedge.

Looking at Europe

A number of U.S. centered studies before this, such as one by Robert Daigler and Laura Rossi in 2006, had found that adding a long volatility position to an underlying equity portfolio has a significant diversification effect. But the authors of the EDHEC paper, Renata Guobuzaite and Lionel Martellini, wanted to determine whether the same benefits can be found in European data.

They find that not only is the performance of EURO STOXX with a volatility or VSTOXX component (of up to 30 percent) superior to that of a 100 percent EURO STOXX portfolio, but that it is also superior to the performance of the so-called global minimum variance portfolio.

GMV portfolios (those on the left end of the cashless, or fully-invested, portfolios’ efficient frontier) “are commonly used in the industry as a practical benchmark for an equity portfolio with a managed downside risk exposure,” the authors say. The question then is whether it is more efficient to hedge against risk by choosing stocks at the low-risk end of the scale, or by using volatility based derivatives.

The EURO STOXX portfolio has an annual volatility of 18.4 percent, by definition riskier than the GMV that Guobuzaite and Martellini use, with a volatility of 16.8 percent. But the STOXX-plus-derivatives portfolio reliably turns in performance superior to that of the GMU

Not-so-hypothetical Gains

Such graphs as that above work with a hypothetical investment. The VSTOXX index used for the diversification component is not itself a tradable instrument, so a portfolio manager has to employ VSTOXX futures or options contracts to create a specific position that will reap this benefit.

One specific possibility is a fully collateralized VSTOXX futures position using the front month futures contract and the full value of that contract held in a bank account paying the EURIBOR interest rate.  This – or anything analogous – raises the danger that transaction costs in general, and the bid-ask spread in particular, will eat up the gain that VSTOXX had won in its hypothetical victory over GMV.

When Guobuzaite and Martellini crunch those numbers, though, that doesn’t happen. The benefits of a long volatility exposure “which are particularly strong during market downturns, are robust with respect to the introduction of trading costs involved in implementation.”

Two Hypotheses

The authors also address the question: why is there a negative correlation in the movements of STOXX and VSTOXX? They offer two hypotheses: the leverage effect and the feedback effect.

On the first view, the key fact is that a fall in the value of a corporation’s equity renders that company, ceteris paribus, more highly leveraged. This increases the risk to equity holders, and that new risk increases the equity volatility. On this view of course, an increase in the value of a corporation’s equity decreases the leverage, decreasing the risk, and decreasing the volatility.

On the second view, the “feedback” view, investors assume that volatility is already incorporated in price. Evidence that they are wrong, in other words volatility shock, will cause an adjustment in price (in the opposite direction from that of the shock).

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One Comment

  1. Charles Dwight, CFA, CAIA
    July 6, 2012 at 1:02 pm

    Interesting article. Unfortunately, in actual implementation, this does not work quite so well. Buying the front month VIX futures carries a significant negative role yield. In the US, this can be seen in the VXX ETF which which maintains a 1 month maturity in VIX futures. VXX has dropped by >95% since its inception in early 2009 to today while the VIX Index has fallen by about 50% over that time. The VIX index does not have a persistent downward trend, but rather is range bound while the VXX has a persistent downward trend. This negative role yield can be significant. Looking at the 1 month vs. the 2 month future today there is an implied negative carry of >9.5%. That is the negative yield for 1 month, if you annualize that, there negative return from holding a long VIX futures position is significant. Although I haven’t done the calculation, the VIX options should exhibit the same negative carry as they are priced off of the VIX futures.

    There are OTC products that will allow the purchaser to recieve actual volatility vs. current implied, but again this would generally carry a negative return except when there is a volatility spike.

    I believe the negative return of these strategies would generally make them unattractive to implement on an ongoing basis.

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