# Volatility Effects

Reward goes with risk, and volatility represents risk. Therefore, volatility means reward; investors/traders get paid for riding roller coasters. Right? These blog entries relate to volatility effects.

**December 21, 2016** - Calendar Effects, Volatility Effects

Does the S&P 500 implied volatility index (VIX) exhibit predictable behaviors around holidays? If so, is the predictability exploitable? To check, we look at percentage changes in VIX from three trading days before to three trading days after the following annual holidays: New Year’s Day, Super Bowl, Good Friday, Memorial Day, 4th of July, Labor Day, Thanksgiving and Christmas. To test exploitability, we employ iPath S&P 500 VIX ST Futures ETN (VXX), exchange-traded notes that hold short-term VIX futures. Using daily closes of VIX and VXX from their respective inceptions (January 1990 and February 2009) through November 2016 (214 and 62 holidays), *we find that:* Keep Reading

**December 14, 2016** - Momentum Investing, Volatility Effects

Does a simple volatility-based risk management approach substantially enhance performance of a Betting-Against-Beta (BAB) strategy (long stocks with low market beta and short stocks with high market beta)? In their November 2016 paper entitled “Managing the Risk of the ‘Betting-Against-Beta’ Anomaly: Does It Pay to Bet Against Beta?”, Pedro Barroso and Paulo Maio examine a BAB risk management strategy that each month weights assets by a volatility target (12% annualized) divided by daily realized strategy volatility over the previous 21 trading days. For comparison, they apply this risk management approach also to other factor strategies based on their respective daily returns. Using daily and monthly BAB returns from AQR and momentum and factor model returns from Kenneth French covering a broad sample of U.S. stocks during July 1963 through December 2015, *they find that:* Keep Reading

**October 19, 2016** - Size Effect, Volatility Effects

Is the finding in “Expected Stock Market Volatility and the Size Effect” that the size effect concentrates in intervals after months of very high stock market volatility robustly evident from liquid exchange-traded funds (ETF)? To investigate, we define the size effect as the difference in returns between iShares Russell 2000 (IWM) and iShares Russell 1000 (IWB) at a monthly frequency and use the CBOE Volatility Index (VIX) as expected market volatility. To check robustness of cited research, we consider:

- Thresholds for high VIX ranging from above average to two standard deviations above average.
- Out-of-sample identification of high monthly VIX values using either inception-to-date (ITD) or rolling 120-month (Rolling120) historical windows of monthly VIX closes.
- Lags between VIX measurements and size effect returns ranging from zero to two months.

We focus on differences in average monthly IWM-IWB returns, standard deviations of IWM-IWB monthly returns and IWM-IWB monthly reward-to-risk ratio (average return divided by standard deviation of returns) for months after high versus not-high values of VIX. Using monthly levels of VIX during January 1990 (inception) through September 2016 and monthly total returns for IWM and IWB during May 2000 (inception) through September 2016, *we find that:* Keep Reading

**October 18, 2016** - Size Effect, Volatility Effects

Is the size effect (small stocks tend to outperform large stocks) related to level of market risk as indicated by expected stock market volatility? In their September 2016 paper entitled “High Risk Episodes and the Equity Size Premium”, Naresh Bansal, Robert Connolly and Chris Stivers investigate the relationship between the size effect and two measures of expected stock market volatility: (1) during 1960 through 1989, realized volatility (RV) calculated from daily stock market returns over the prior 66 trading days; and, (2) during 1990 through 2014, the CBOE Volatility Index (VIX). To measure the size effect, they focus on Fama-French SMB factor portfolio monthly returns (return of the tenth, or decile, of stocks with the smallest market capitalizations minus the return of the decile of stocks with the largest market capitalizations). They also study return differences between each of the next three smallest deciles and the return of the largest decile. They consider both value weighting and equal weighting of stock deciles. They insert a skip-month between the volatility measurement interval and size effect return measurement intervals of 1, 3, 6 or 12 months. Using the specified monthly and daily data, *they find that:* Keep Reading

**October 17, 2016** - Momentum Investing, Volatility Effects

Does adjusting leverage based on lagged strategy volatility protect an industry momentum strategy from crashes? In their September 2016 paper entitled “Risk-Managed Industry Momentum and Momentum Crashes”, Klaus Grobys, Joni Ruotsalainen and Janne Aijo investigate the profitability of risk-managed industry momentum strategies. Their asset universe consists of the 49 Fama-French value-weighted industry portfolios. They focus on a conventional momentum strategy that each month takes equally weighted long positions in past winners (top eight industries) and short positions in past losers (bottom eight industries) based on cumulative returns from 12 months ago to one month ago (12-2). They also analyze 6-2 and 12-7 variations to determine whether more recent or older past returns drive results. For risk management, they forecast next-month momentum strategy volatility based on past strategy volatility calculated based on daily returns over the past one, three or six months. They apply the volatility forecasts to determine the portfolio leverage required to target constant 12% annualized volatility. Using monthly and daily returns for the 49 industries during July 1926 through September 2014, *they find that:* Keep Reading

**October 11, 2016** - Equity Premium, Volatility Effects

Does identification of trends in the CBOE Volatility Index (VIX) via simple moving averages (SMA) support effective timing of the U.S. stock market or VIX futures exchange-traded notes (ETN)? to investigate we consider timing four asset pairs:

- SPDR S&P 500 (SPY) – ProShares Short S&P500 (SH) since SH inception on 6/21/06.
- SPY – iShares 1-3 Year Treasury Bond (SHY) since 6/21/06.
- VelocityShares Daily Inverse VIX ST ETN (XIV) – iPath S&P 500 VIX ST Futures ETN (VXX) since XIV inception on 11/30/10.
- XIV – SHY since 11/30/10.

SPY and XIV are offensive assets, and SHY and VXX are defensive assets. We consider five individual SMAs to determine VIX trend: 200-day (SMA200); 100-day (SMA100); 50-day (SMA50); 20-day (SMA20); and, 10-day (SMA10). We also consider one “majority rules” combination wherein at least three of the five individual SMAs agree (SMA-Multi). When daily VIX is above (below) its SMA, expected stock market volatility is trending up (down), and we hold the defensive (offensive) asset of the above pairs. We assume a baseline 0.1% for asset switching frictions. Using daily values of the above assets as specified through most of September 2016 (10.3 years for SPY pairs and 5.8 years for XIV pairs), *we find that:* Keep Reading

**October 10, 2016** - Volatility Effects

Is the term structure of CBOE Volatility Index (VIX) futures useful for timing the underlying stock index? In the February 2012 version of his paper entitled “The Relationship between VIX Futures Term Structure and S&P500 Returns”, Athanasios Fassas relates the VIX futures term structure to both contemporaneous and future S&P500 Index returns. He measures the VIX futures term structure as the slope of a best-fit line for VIX (spot value) and closing prices for available VIX futures as a function of time to maturity. He rolls futures such that no contract in the calculation is within two weeks of maturity. He tests relationships between change in VIX futures term structure and S&P 500 Index return via regressions run at frequencies of one day, one week, two weeks, one month and two months, with the sample winnowed in each case so that measurements do not overlap. Using daily closing prices of spot VIX and the six nearest VIX futures with at least two weeks to maturity during late March 2004 through July 2010, *he finds that:* Keep Reading

**September 26, 2016** - Size Effect, Value Premium, Volatility Effects

Do investors exploiting common stock return anomalies risk extraordinarily large drawdowns during market crashes? In their May 2016 paper entitled “Can Exposure to Aggregate Tail Risk Explain Size, Book-to-Market, and Idiosyncratic Volatility Anomalies?”, Sofiane Aboura and Eser Arisoy investigate whether portfolios based on the size, book-to-market ratio and idiosyncratic volatility effects bear elevated stock market tail risk. They measure market tail risk as change in VIX Tail Hedge Index (VXTH), which hedges extreme drops in the S&P 500 Index by holding the index and one-month far out-of-the-money (30-delta) call options on the CBOE Volatility Index (VIX). They test sensitivity of size and book-to-market factors to overall risk and tail risk by adding change in VIX (market volatility risk factor) and change in VXTH (market tail risk factor) to the Fama-French three-factor (market, size, book-to-market) model of stock returns. They consider two equal subperiods, one containing the 2008 financial crisis, to check robustness of findings. Using monthly values of VIX and VXTH, factor model returns and U.S. Treasury bill yields during January 2007 through February 2016 (110 months), *they find that:* Keep Reading

**September 9, 2016** - Sentiment Indicators, Volatility Effects

Should investors buy or sell stocks experiencing unique (idiosyncratic) volatility spikes? In their August 2016 paper entitled “Unusual News Flow and the Cross-Section of Stock Returns”, Turan Bali, Andriy Bodnaruk, Anna Scherbina and Yi Tang investigate relationships among sudden increases in stock idiosyncratic volatility, unusual firm news, changes in analyst earnings forecast dispersion, short selling and future returns. They identify idiosyncratic volatility shocks as large deviations from the volatility predicted out-of-sample by a regression model that accounts for market, size and book-to-market effects. They identify unusual news flow using Thomson-Reuters News Analytics data (covering 41 media) by comparing the number of stories about a firm in the current month to the average monthly coverage the prior four months, measured overall and separately for positive, negative and neutral stories. They measure changes in analyst earnings forecast dispersion (standard deviation divided by mean) based on data from I/B/E/S as the difference between current dispersion and dispersion two months ago. They measure data on shorting demand and utilization (shares borrowed divided by shares available for lending) using data from Markit. Using monthly values of the specified data from various inceptions through December 2012, *they find that:* Keep Reading

**August 9, 2016** - Volatility Effects

Does the Fama-French five-factor model of stock returns (employing market, size, book-to-market, investment and profitability factors) explain the outperformance of low-volatility stocks. In their July 2016 paper entitled “The Profitability of Low Volatility”, David Blitz and Milan Vidojevic examine whether: (1) any of several models expose a conventional return-for-risk market beta effect for stocks; and, (2) the low-volatility effect is distinct from a low-beta effect. They calculate volatilities for stocks and the market using daily or monthly returns over the past year. They calculate stock betas using these volatilities and daily or monthly stock-versus-market return correlations over the past five years, with shrinkage by 1/3 toward a value of one. They include momentum (return from 12 months ago to one month ago) as an explanatory factor, even though the five-factor model does not. Using data for a broad sample of U.S. common stocks and model factors (excluding extreme outliers) during July 1963 through December 2015, *they find that:* Keep Reading