CBOE to offer futures on VIX volatility index

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The Chicago Board Options Exchange (CBOE) last month released a revamped version of its Volatility Index (VIX), traditionally a barometer of US equity market volatility, and will release a series of futures contracts – to be followed later by other derivatives – on the index in the fourth quarter of this year.

Since its inception in 1993, the VIX has been based on prices on the S&P 100 index options. The CBOE decided to update the methodology and, after consulting with the major equity derivatives dealers, to base it around the more liquid S&P 500 index. This index trades $16.9 billion of notional index options a day, compared with $2.5 billion of daily notional on the S&P 100, and is arguably a more relevant indicator of trends in the equity markets.

The CBOE based the pricing formula for the new options on papers written on variance swaps by sometime Risk columnist Emanuel Derman while he was head of Goldman Sachs’ quantitative risk strategies group in firm-wide risk. The new methodology is based on prices for all strikes on the S&P 500 index options, which means the price for derivatives is much less sensitive to individual option values.

“The new product captures the entire volatility skew by using the entire set of option strikes and not just the at-the-money strikes as previously,” says Srikant Dash, index strategist at Standard & Poor’s (S&P) in New York. S&P worked with the CBOE in the analytical development and marketing of the index, and is the senior partner and owner of the index.

Sandy Rattray, equity derivatives strategist at Goldman Sachs, says the main reason for creating the new index and the options and futures based on it is to give market participants a much more efficient tool to trade volatility. The payout on the VIX derivatives is the difference between the implied volatility level quoted on the derivatives and the realised volatility over the maturity of the contract. An advantage of the new VIX is that the square of the index can be hedged using a strip of static options. This is a big difference from the old methodology, which made it very complex for investors wanting to trade implied volatility.

The VIX derivatives differ from variance swaps, which are based on realised volatility rather than implied volatility. However, John Hiatt, director in product development at the CBOE, says the exchange plans to release more products that will look at the realised volatility levels of the underlying, such as variance swaps, as well as cash-settled options as the market matures. The involvement of the exchange brings the advantage of having a central clearing counterparty for participants. Each lot on the new contract is expected to be around 500 times the index level at expiry, and will have maturities of one, three and six months, though this depends on gaining regulatory approval.

The CBOE will also be releasing futures contracts on its VXN volatility index, which is referenced to the Nasdaq 100 index. The VXN calculation methodology has also been updated to include the full range of option strikes. The exchange expects to attract interest from hedge funds and other volatility players looking to trade volatility, and also to hedge positions on the underlying indexes.

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