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It’s official. Volatility is back in vogue.
On Wednesday the Vix index, which is derived from the value of S&P 500 options, posted its biggest two-day increase in nine months following a sharp fall in S&P 500 equities on renewed fears about the robustness of the global economic recovery.
All of which is good news for the CBOE, the keeper of the Vix futures contract. The product is already viewed by the option specialist as one of its key growth areas, contributing to the bulk of the group’s performance over the last year. It also remains the focus area for the group, moving the CBOE further away from its traditional options expertise.
What’s interesting though is that the biggest increase in Vix futures volumes happened over the course of last year, when volatility was largely low.
According to the CBOE, volume in VIX futures in January 2011 was up 253 per cent on the year, but it’s not a one-month glitch. Growth has been steady over the year.
Much of that, according to the CBOE, is related to the rise in popularity of Vix-related exchange traded notes — the number offered on the market is growing by the minute.
So it’s safe to presume that this week’s volatility pick-up will have energised that particular sector too.
But is there a price discovery problem?
Given the above, it’s understandable why talk has been floating back to the shape of Vix term structure. This, readers will see below, remains in very steep contango:
The conventional view is to see this as the market pricing in — or even forecasting — more volatility in the months to come.
The problem is that over the last year or so the Vix futures curve has proved particularly bad at forecasting volatility this way.
As one Vix market maker told FT Alphaville recently:
Since about March 2009 long-term volatility assumptions have been much much higher than actual volatility.
Not only does that discredit Vix futures as a forecasting tool, it suggests some pretty shoddy pricing on both the part of the Vix futures market and S&P options market.
The no arbitrage rule after all suggests the two markets must converge, since Vix futures expire at a level which must match the volatility level derived from S&P options.
So why this most hideous forecasting track record of late?
Potentially it could be connected to the way the price discovery process in both markets has evolved over the last two years. As the same market-maker told us:
There are more people taking positions in the Vix futures alone, while before it used to be the other way round (more people using options). Options used to be the drivers of the futures prices. Now you’re looking at people taking positions in Vix futures and just the futures, without necessarily an options leg to the trade.
Which begs the question: have we come to the point where longer-dated S&P options are beginning to be priced off Vix futures, which themselves are being influenced by rising demand (on the long side) from Vix fund positioning?
In other words, are futures prices wagging the options market?
It sounds remarkable; but in an environment where options liquidity is lower than Vix futures, it is possible.
We would further add that putting blind faith in any futures price for forecasting purposes is never a good idea. It’s well known that futures have always been poor at predicting the future in any market.
In the words of Reuters’ John Kemp:
The forward curve shows the price at which it is possible to buy or sell futures contracts for a forward date at a price agreed today. It is not a forecast.
On that basis, Vix futures should not be seen any differently .
Related links: Skewed "“ the CBOE's new fear indicator - FT Alphaville Motivational indexing – FT Alphaville A Vix curve ball – FT Alphaville Correlation remains at highs reached in the crisis – FT
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