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Indices and Benchmarking - October 09, 2012

The Risks of Volatility ETNs: a Recent Incident and Underlying Issues - an interview with Stoyan Stoyanov

EDHEC-Risk Institute recently published a research paper entitled "The Risks of Volatility ETNs: a Recent Incident and Underlying Issues." In this interview, co-author Stoyan Stoyanov, Head of Research at EDHEC Risk Institute—Asia, provides background to some of the key questions addressed by the publication.

Stoyan Stoyanov

In the publication "The Risks of Volatility ETNs: a Recent Incident and Underlying Issues" you discuss the Credit Suisse TVIX controversy from earlier this year. Could you tell us about your conclusions on the causes of this controversy?

Stoyan Stoyanov: TVIX is a leveraged volatility ETN issued by Credit Suisse which became very popular at the beginning of 2012. At the end of February, Credit Suisse discontinued issuance of new shares of TVIX, which caused the value of TVIX to deviate from the indicative value of the contract on the secondary market. Thus, in the presence of limited supply, the high demand for the contract led to the accumulation of a positive premium.

In normal circumstances, market players may be able to short-sell the contract, hedge their position, and profit from the premium which would, in turn, reduce it. In the case of TVIX, although short-selling did intensify, difficulties in borrowing the contract proved a limiting factor for massive short-selling. There were also indications of a short squeeze – sophisticated market participants tried to short-sell but then had to cover their positions in a rising market. As a consequence, the positive premium skyrocketed to more than 80% in March 2012. The premium contracted suddenly when Credit Suisse made an announcement that issuance could be resumed, which resulted in significant losses for investors.

In addition to a discussion on the TVIX incident, your research focuses on volatility ETNs in general. What are some of the issues with volatility ETNs that investors should be aware of?

Stoyan Stoyanov: The performance of volatility ETNs, and volatility exchange-traded products in general, including volatility ETFs, is linked to the performance of a constant maturity portfolio of volatility futures which is constructed through a roll-over strategy. There are two important implications for investors.

Firstly, volatility ETNs do not provide a direct exposure to market volatility as measured by the option-implied volatility index (e.g. VIX). The volatility index is not traded, meaning that there is no cash-and-carry arbitrage link between the price of volatility futures and the volatility index which holds for futures on traded assets. Therefore, the link between the two remains, essentially, a statistical one and investors in volatility ETNs (or ETFs for that purpose) seeking an exposure to volatility should keep in mind that this exposure materialises indirectly through a portfolio of volatility futures.

Secondly, the volatility futures term structure is in contango most of the time, which means futures prices decrease with time to maturity and, therefore, a significant cost may be associated with the roll-over. In fact, the term structure is steeper for smaller maturities which means that the 1-month constant maturity portfolio has a higher roll-over cost than the 5-month one. On the other hand, the shorter maturity portfolios are more sensitive to the volatility index. This means that, generally, holding volatility ETNs for an extended period of time can be quite costly, even if the ETN is not leveraged, with the cost usually being higher for ETNs, which are more sensitive to the volatility index.

There is apparently some confusion between volatility ETNs and volatility ETFs. Could you describe some of the differences?

Stoyan Stoyanov: There is confusion between ETNs and ETFs in general. In fact, there is a case to be made that if TVIX were a volatility ETF, the market distortion would not have occurred because of the differences in the share creation processes of ETFs and ETNs. ETFs are generally characterised by a transparent and fluid share creation process which makes sure the price of the ETF does not deviate substantially from the indicative value. For example, in the case of a volatility ETF, should a positive premium start accumulating, arbitrageurs can redeem the underlying volatility futures portfolio for ETF units, which can then be sold on the market. In the case of a negative premium the converse can be done. As long as there are no liquidity issues or any legal constraints and this mechanism can function, the price of a volatility ETF would stay close to the indicative value. In fact, UVXY is a leveraged volatility ETF tracking the same index as TVIX and during the period of the TVIX market distortion UVXY showed no signs of problems.

In contrast to ETFs, new shares of ETNs can be created only by the corresponding issuer. For TVIX, this would be Credit Suisse. Through the share creation process, the issuer makes sure the ETN price is close to the indicative value. However, in the absence of a market mechanism for investors to create shares, once the issuer discontinues share creation, experience shows that a positive premium can build up. This is by no means limited to volatility ETNs only, another notable example is GAZ, a natural gas ETN.

As Head of Research with EDHEC Risk Institute—Asia, you have devoted considerable efforts to studying volatility. What are some of the other research findings in this area that might be of interest to investors?

Stoyan Stoyanov: A common piece of investment advice in the industry is that since volatility indices are generally very correlated in significant market downturns, investors seeking an exposure to a volatility product should focus only on the most liquid volatility derivative market, which the is one based on the S&P500 option-implied volatility index, or VIX. Although academic research indeed finds a significant volatility spill-over effect from developed to emerging markets in times of big market crashes, we can also make the case that local equity market volatility factors exist. In Asia, for example, this is easy to demonstrate for India and China but also holds for markets such as Japan, Hong Kong, and Korea, which are more integrated in the global economy. On some of these markets, volatility futures based on local volatility indices have already started emerging – in Hong Kong and Japan since February 2012.

Having said this, investors with exposure to the equity markets of these countries need to be careful about two important aspects before jumping to the conclusion that the best course of action is buying local volatility futures. The first one is whether the local volatility futures prices provide a reliable exposure to the underlying volatility index. As previously mentioned, this connection is essentially statistical. The second one is more subtle but perhaps more important – does the volatility index provide a reliable estimate for option-implied volatility? Failure to do so may be caused by an immature index option market. In fact, academic research indicates that even VIX is an imperfect proxy for the implied volatility of S&P500 – it underestimates the true implied volatility when it is high and overestimates it when it is low.

About Stoyan Stoyanov

Stoyan Stoyanov is Professor of Finance at EDHEC Business School and Head of Research at EDHEC Risk Institute–Asia. He has ten years of experience in the field of risk and investment management. Prior to joining EDHEC Business School, he worked for over six years as head of quantitative research for FinAnalytica. He has designed and implemented investment and risk management models for financial institutions, co-developed a patented system for portfolio optimisation in the presence of non-normality, and led a team of engineers designing and planning the implementation of advanced models for major financial institutions.

His research focuses on probability theory, extreme risk modelling, and optimal portfolio theory. He has published over thirty articles in leading academic and practitioner-oriented scientific journals such as Annals of Operations Research, Journal of Banking and Finance, and the Journal of Portfolio Management, contributed to many professional handbooks and co-authored three books on probability and stochastics, financial risk assessment and portfolio optimisation. He holds a master in science in applied probability and statistics from Sofia University and a PhD in finance from the University of Karlsruhe.

Stoyan Stoyanov's CV can be found here.