Last Updated on 10 February, 2024 by Rejaul Karim
The research paper “Understanding ETNs on VIX Futures,” authored by Carol Alexander of the University of Sussex Business School and Dimitris Korovilas of the University of Reading, unravels an intricate discourse, poised to augment transparency in the domain of direct, leveraged, and inverse exchange-traded notes (ETNs) on VIX futures.
Wielding a momentous impetus, the study delves into the pulsating enigma of volatility trading, fervently binding its clarion call with the judicious solicitude of regulators, who harbor profound concerns over the prevailing lack of comprehension bedewing many market players.
Drenched in epochal significance, the paper extends a resonant plea to exchanges, market-makers, issuers, potential investors, and regulators to implore their acquiescence in fostering a deeper cognitive grasp of these ETNs, as stellar stewards of the market.
The authors’ meticulous explication engulfs the uncompromising milieu of roll yield and convexity effects, encapsulating the epochal zest, weaved through the fabric of volatility and performance assessments over an eight-year trajectory, elucidating their statistical underpinnings and resounding repercussions.
Abstract Of Paper
This paper aims to improve transparency in the market for direct, leveraged and inverse exchange-traded notes (ETNs) on VIX futures. The first VIX futures ETNs were issued in 2009. Now there are about 30 of them, with a market cap of about $3 billion and trading volume on some of these products can reach $5 billion per day. Yet volatility trading is highly complex and regulators are rightly concerned that many market participants lack sufficient understanding of the risks they are taking. We recommend that exchanges, market-makers, issuers and potential investors, as well as regulators, read this paper to improve their understanding of these ETNs.
We provide a detailed explanation of the roll yield and convexity effects that drive the returns on VIX futures ETNs, and we track their volatility and assess their performance over an eight-year period starting in March 2004, by replicating their values using daily close VIX futures prices. We explain how ETN issuers can construct almost perfect hedges of their suite of ETNs and control their issue (most ETNs are callable) to make very significant profits under all bootstrapped scenarios. However, market knowledge has precipitated front-running of the issuer’s hedging activities, making profits more difficult to control. Moreover, for hedging the ETNs such large positions must be taken on VIX futures that the ETN market now leads the VIX futures that they are supposed to track. The result has been an evident increase in the volatility of VIX futures since 2009. If this increase in statistical volatility induces an increase in VIX futures implied volatility, a knock-on effect would be higher prices of VIX options whilst S&P options are unaffected.
A previous discussion paper, Alexander and Korovilas (2012), provided incontrovertible evidence that single positions on direct VIX futures ETNs of any maturity – including mid-term and longer-term trackers – could only provide a diversification/hedge of equity exposure during the first few months of a great crisis of similar magnitude to the banking collapse in late 2008. By contrast, the present discussion paper shows that some highly attractive long-term investment vehicles can be simply constructed by holding certain portfolios of VIX futures ETNs. In particular, we introduce a new class of ‘roll-yield arbitrage’ ETN portfolios which we call ETN2 (because they allocate between direct and inverse VIX futures tracker ETNs) and ETN3 portfolios (that allocate between static and dynamic ETN2). These portfolios have positive exposure to mid-term direct-tracker ETNs and (typically) negative exposure to short-term direct-tracker ETNs (equivalently, positive exposure to short-term inverse-tracker ETNs). Their unique risk and return characteristics make them highly attractive long-term investments, as well as superb diversifiers of stocks, bonds and commodities.
Original paper – Download PDF
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University of Sussex Business School; Peking University HSBC Business School
University of Reading – ICMA Centre
In an effulgent culmination, “Understanding ETNs on VIX Futures” unravels a pristine panorama encapsulating a compendium of insights etched with the steely resolve to congeal transparency in the labyrinthine market of exchange-traded notes tethered to VIX futures.
A magnum opus ahead of its time, the vivid resplendence encapsulated within the hallowed narratives and impassioned delves into roll yield and convexity effects resound with the clarion call, transcending the entwined fugue of volatility and performance assessments, shrouding the annals of history with its shimmering resplendence.
A lustrous beacon, beckoning exchanges, market-makers, issuers, potential investors, and regulators – entreating their inveiglement into the effusive dictates of comprehension enshrined within the tapestry of these ETNs, as zealously stewarded by the authors.
The vivacity encapsulated within the oeuvre emerges as a lodestar of enlightenment, aggrandizing the quintessence of market knowledge, poised to ennoble and invigorate the ebb and flow of ETNs on VIX futures, emancipating an enduring paeans of insights and wisdom to the burgeoning domain.
1. What is the main objective of the research paper “Understanding ETNs on VIX Futures” and why is transparency in the market for direct, leveraged, and inverse exchange-traded notes (ETNs) on VIX futures considered crucial?
The primary objective of the research paper is to enhance transparency in the market for direct, leveraged, and inverse exchange-traded notes (ETNs) on VIX futures. The authors emphasize the complexity of volatility trading and express concerns from regulators regarding the insufficient understanding of risks among market participants. The paper seeks to unravel the intricacies of VIX futures ETNs, providing insights into roll yield and convexity effects, and urging key stakeholders such as exchanges, market-makers, issuers, potential investors, and regulators to improve their comprehension of these financial instruments.
2. What are the key findings and recommendations presented in the paper regarding the returns, volatility, and performance of VIX futures ETNs over an eight-year period starting in March 2004?
The paper delves into the roll yield and convexity effects that drive the returns on VIX futures ETNs, tracking their volatility and assessing performance over an eight-year period. It highlights how ETN issuers can construct almost perfect hedges and control issuance to generate significant profits under various scenarios. However, the discussion also reveals challenges, such as front-running of issuer hedging activities and the impact on the volatility of VIX futures. The paper recommends that stakeholders read the findings to improve their understanding and suggests that some portfolios of VIX futures ETNs, particularly new classes like ‘roll-yield arbitrage’ portfolios (ETN2 and ETN3), can be attractive long-term investments and effective diversifiers.
3. How does the research paper contribute to the understanding of the relationship between VIX futures ETNs and market dynamics, and what is the significance of introducing the concept of ‘roll-yield arbitrage’ portfolios?
The paper contributes to understanding the relationship between VIX futures ETNs and market dynamics by providing insights into the construction of hedges, challenges faced by ETN issuers, and the impact on the volatility of VIX futures. It introduces the concept of ‘roll-yield arbitrage’ portfolios (ETN2 and ETN3), showcasing them as attractive long-term investments and effective diversifiers of stocks, bonds, and commodities. The significance lies in presenting these portfolios as alternatives with unique risk and return characteristics, challenging the notion that single positions on direct VIX futures ETNs may only provide diversification during crises.