Volatility Effects

Are there ways to enhance the currency carry trade (long currencies offering high interest rates and short those offering low rates)? In the May 2012 version of their paper entitled “Average Variance, Average Correlation and Currency Returns”, Gino Cenedese, Lucio Sarno and Ilias Tsiakas investigate the ability of components of the currency exchange market risk (variance of the average return for all exchange rates) to predict carry trade returns. Their baseline carry trade portfolio involves U.S. dollar nominal exchange rates, rebalanced monthly. They decompose the market variance into two components: average variance of individual exchange rate returns, and average correlation of exchange rate returns. They examine the effects of changes in these risk components on the entire future distribution of currency trade returns (via quantile breakdowns), focusing on the large losses in the left tail and large gains in the right tail. Using daily spot and forward exchange rates for 33 currencies relative to the U.S. dollar as available during 1976 through February 2009 (15 active exchange rates at the beginning and 22 at the end), they find that: More…

Are there exchange-traded notes (ETN) based on S&P 500 Index implied volatility (VIX) futures, or combinations of such ETNs, that are attractive for absolute return and diversification? In their April 2012 paper entitled “Understanding ETNs on VIX Futures”, Carol Alexander and Dimitris Korovilas examine the behaviors of simple (first generation) and enhanced (second generation) ETNs constructed from VIX futures. They focus on: (1) roll return or yield, the gain (loss) of maintaining a position in VIX futures by continually rolling from a near to a far maturity contract when in contango (backwardation); and, (2) term structure convexity of VIX futures, the generally greater magnitude of roll return when rolling between contracts near to maturity versus between contracts far from maturity. To extend the sample period, they replicate recently available ETNs back to December 2005 using S&P constant-maturity VIX futures indexes and March 2004 using daily closes of VIX futures. Using daily closes for all VIX futures contracts, 30-day (VIX) and 93-day (VXV) S&P 500 implied volatility indexes as calculated by CBOE, S&P constant-maturity VIX futures indexes, one-month (VXX) and five-month (VXZ) constant-maturity VIX futures ETNs and two recently launched second-generation VIX futures ETNs (XVIX and XVZ) as available from late March 2004 through December 2011, they find that: More…

Does the variance risk premium (derived from the mostly positive gap between options-implied equity market volatility and actual equity market volatility) robustly predict stock market returns worldwide? In the March 2012 version of their paper entitled “Stock Return Predictability and Variance Risk Premia: Statistical Inference and International Evidence”, Tim Bollerslev, James Marrone, Lai Xu and Hao Zhou test the statistical and geographic robustness of the power of the aggregate variance risk premium to predict overall stock market returns. Statistical robustness testing addresses sampling frequency and the use of overlapping measurement intervals. Geographic robustness testing involves measurement of the variance risk premium for French CAC 40, the German DAX 30, the Japanese Nikkei 225, the Swiss SMI and the UK FTSE 100. While tests in past research employ monthly data, they calculate the implied-realized volatility gap for the U.S. by subtracting a measure of the actual S&P 500 Index return variance over the past 20 trading days from the square of VIX (see the chart below). Using S&P 500 Index daily returns and VIX levels for February 1996 through December 2007 and comparable data for other country stock markets for January 2000 through December 2011, they find that: More…

Do economic announcements systematically remove uncertainty from financial markets and thus reliably lower implied volatility indexes? In their September 2010 paper entitled “The Impact of Macroeconomic Announcements on Implied Volatilities”, Roland Füss, Ferdinand Mager and Lu Zhao measure the reactions of the Chicago Board Options Exchange Volatility Index (VIX) and the DAX Volatility Index (VDAX) to U.S. and German macroeconomic announcements. They consider announcements of Gross Domestic Product (GDP), the Producer Price Index (PPI) and the Consumer Price Index (CPI). The measurement interval is apparently close-to-close from the day before to the day of announcement. Using monthly/quarterly macroeconomic announcement dates from January 2005 through December 2009 and contemporaneous daily data for VIX and VDAX (60 months), they find that: More…

One finding of “Exploiting VXX/XIV Tendencies” is that shorting iPath S&P 500 VIX Short-Term Futures ETN (VXX) with crash protection may be very attractive. To investigate, we consider applying a very simple crash protection rule to a default short position in VXX. Using monthly closes for the S&P 500 Volatility Index (VIX) and monthly adjusted closing prices for VXX from January 2009 through March 2012 (39 months), we find that: More…

A subscriber inquired about strategies for trading exchange-traded notes (ETN) constructed from near-term S&P 500 Volatility Index (VIX) futures: iPath S&P 500 VIX Short-Term Futures ETN (VXX) and VelocityShares Daily Inverse VIX Short-Term (XIV), available since 1/30/09 and 11/30/10, respectively. The managers of these securities buy and sell VIX futures daily to maintain a constant maturity of one month (long for VXX and short for XIV), continually rolling partial positions from the nearest term contract to the next nearest. We consider three potential predictors of the price behavior of these securities:

1. The level of VIX, in case a high (low) level indicates a future decrease (increase) in VIX that might affect VXX and XIV.
2. The change in VIX, in case there is some predictable reversion or momentum for VIX that might affect VXX and XIV.
3. The term structure of VIX futures (roll return) underlying VXX and XIV, as measured by the slope of futures prices from nearest to furthest available expirations, indicating a price headwind or tailwind for a fund manager rolling from the nearest contract to the next nearest. This slope is usually positive (contango), but occasionally negative (backwardation).

Using daily levels of VIX, daily prices for VIX futures contracts, and daily adjusted prices for VXX and XIV from inceptions of the ETNs through mid-April 2012, we find that: More…

For which stocks does market-adjusted (idiosyncratic) volatility work as an indicator of future returns (see “No Reward for Risk?”)? In their January 2012 paper entitled “Dissecting the Idiosyncratic Volatility Anomaly”, Linda Chen, George Jiang, Danielle Xu and Tong Yao measure the idiosyncratic volatility premium in different subsamples of U.S. stocks. To measure the premium, they focus on differences in average monthly returns and four-factor (market, size, book-to-market, momentum) alphas between both value-weighted and equal-weighted top and bottom deciles of prior-month idiosyncratic volatility. They consider the following stock universe subsamples: (1) common stocks and non-common stocks; (2) microcap, small and big stocks (breakpoints at the 20th and 50th percentiles of NYSE stock capitalizations); (3) stocks priced above $10, between $5 and $10 and below $5; and, (4) January and non-January returns. Using daily returns for NYSE/AMEX/NASDAQ common and non-common stocks, and for a value-weighted market index, to calculate monthly idiosyncratic volatility during 1963 through 2010, they find that: More…

Market volatility tends to rise as returns fall. Does adding a proxy for intermediate-term U.S. equity market volatility to a diversified portfolio improve its performance? To check, we add iPath S&P 500 VIX Mid-Term Futures (VXZ) to the following mix of asset class proxies (the same used in “Simple Asset Class ETF Momentum Strategy”):

PowerShares DB Commodity Index Tracking (DBC)
iShares MSCI Emerging Markets Index (EEM)
iShares MSCI EAFE Index (EFA)
SPDR Gold Shares (GLD)
iShares Russell 1000 Index (IWB)
iShares Russell 2000 Index (IWM)
SPDR Dow Jones REIT (RWR)
iShares Barclays 20+ Year Treasury Bond (TLT)
3-month Treasury bills (Cash)

First, per the findings of “Asset Class Diversification Effectiveness Factors”, we measure the average monthly return for VXZ and the average pairwise correlation of VXZ monthly returns with the monthly returns of the above assets. Then, we compare cumulative returns and basic monthly return statistics for equally weighted (EW), monthly rebalanced portfolios with and without VXZ. We ignore rebalancing frictions, which would be about the same for the alternative portfolios. Using adjusted monthly returns for VXZ and the above nine asset class proxies from March 2009 (first return available for VXZ) through March 2012 (only 37 monthly returns), we find that: More…

Should investors diversify U.S. equity holdings with S&P 500 volatility index (VIX) futures or exchange-traded notes (ETN) constructed from these futures? In the March 2012 version of their paper entitled “Diversification of Equity with VIX Futures: Personal Views and Skewness Preference”, Carol Alexander and Dimitris Korovilas examine the performance and equity diversification power of VIX futures. They focus on ETNs with one-month constant maturity, available since January 30, 2009 as VXX (iPath S&P 500 VIX Short Term Futures), and five-month constant maturity, available since February 20, 2009 as VXZ (iPath S&P 500 VIX Mid-Term Futures). They extend these proxies back to December 2005 using matched S&P 500 VIX futures constant maturity index series and further back to April 2004 using futures price data and the Standard & Poor’s methodology. They use SPDR S&P 500 (SPY) to represent equity exposure. For diversity in equity market conditions, they consider three subperiods: April 2004 through September 2006 (tranquil); October 2006 through March 2009 (crisis); and, April 2009 through December 2011 (punctuated volatility). When examining VIX futures contract returns, they roll five days prior to maturity to avoid the effect of maturity on final settlement. Using daily data for SPY, VIX futures, VIX futures indexes, VXX and VXZ as available from March 26, 2004 (the inception of VIX futures) through December 2011, they find that: More…

In general, when the U.S. stock market goes down, the S&P 500 volatility index (VIX) goes up. VIX is not investable, but VIX futures are available. Are short-term VIX futures a good way to hedge equity market declines and guard against market blow-ups? To investigate we focus on returns from holding the contract nearest to maturity, rolling to the next nearest on maturity dates. For simplicity, we assume that rolling is frictionless (favorable to futures) and that available capital always matches a round number of futures contracts (no residual cash). Using daily levels of VIX and daily settlement values of all VIX futures series from late March 2004 through late March 2012 (eight years), we find that: More…