Volatility Derivatives in Practice: Activity and Impact

Scott Mixon

Commodity Futures Trading Commission

Esen Onur

Commodity Futures Trading Commission (CFTC)

Abstract:

We use unique regulatory data to examine open positions and activity in both listed and OTC volatility derivatives. Gross vega notional outstanding for index variance swaps is over USD 2 billion, with dealers short vega in order to supply the long vega demand of asset managers. For maturities less than one year, VIX futures are far more actively traded and have a higher notional amount outstanding than S&P 500 variance swaps. To the extent that dealers take on risk when facilitating trades, we estimate that the long volatility bias of asset managers puts upward pressure on VIX futures prices. Hedge funds have offset this potential impact by actively taking a net short position in nearby contracts. In our 2011?2014 sample, the net impact added less than half a volatility point, on average, to nearby VIX futures contracts but added between one and two volatility points for contracts in less liquid, longer?dated parts of the curve. We find no evidence that this price impact forces VIX futures outside no?arbitrage bounds.

Volatility Derivatives in Practice: Activity and Impact – Introduction

Are VIX?linked products distorting the VIX? Some commenters have questioned whether VIX-linked products (Exchange Traded Funds or Exchange Traded Notes) have grown so popular that the hedging activities of the issuers dominate and distort the VIX futures market. Pessimists ask if liquidity?driven disruptions in VIX ETN markets are being transmitted to the VIX futures markets; optimists point to increased (indirect) participation in futures markets providing better liquidity and more informative pricing. Analysis is complicated by the fact that related volatility derivatives are actively traded in the OTC market, and little is known about the trading activity in that space.

We use unique regulatory data on both OTC variance swaps and exchange?listed VIX futures to evaluate the activity and impact of volatility derivatives trading. This study is the first to use the market?wide regulatory data on variance swap transactions mandated by the Dodd?Frank Wall Street Reform and Consumer Protection Act. A subset of the transactions data is reported publicly and has been examined by Dew?Becker, Giglio, Le and Rodriguez (2014), but the publicly available data lacks counterparty information and other confidential details. Both the swaps and futures data we examine include information on the participant holding any particular reported position; we are therefore able to link precisely the participant type with the positions and need not estimate such relationships.

We find that gross vega notional outstanding for index variance swaps is over USD 2 billion, with USD 1.5 billion in S&P 500 products and nearly USD 500 million across five other major indexes across the globe. Dealers are net short vega in order to supply the long variance swap demand of unlevered asset managers. For maturities less than one year, VIX futures are far more actively traded and have twice as much notional vega outstanding than S&P 500 variance swaps.

To the extent that dealers take on risk when facilitating trades, we estimate that the long volatility bias of asset managers acts to put upward pressure on VIX futures prices. Hedge funds have offset this potential impact because they have actively taken a net short position in nearby contracts. In our 2011?2014 sample of VIX futures, the net impact added less than half a volatility point in nearby contracts, on average, but between one and two volatility points for contracts in less liquid, longer?dated parts of the curve. The impact of non?dealer positioning has evolved over time as the demands of the various participant types have changed. In 2011 and 2012, for example, unlevered asset managers were long and hedge funds were not active, and we conclude that this positioning increased front?month VIX futures approximately one volatility point. By 2013, hedge funds took sizeable short positions and the estimated impact fell to roughly zero.

Volatility Derivatives

Volatility Derivatives

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