VIX options more flexible for managing volatility risk

PUBLISHED : Wednesday, 15 December, 2010, 12:00am
UPDATED : Wednesday, 15 December, 2010, 12:00am

Once the Hang Seng VIX Index is introduced this month, the futures and options contracts using VIX as an underlying asset should be developed and launched, says Stephen Figlewski, professor of finance at the Leonard N Stern School of Business at New York University.

'VIX futures contracts are essential. Vega hedging by market makers using VIX futures [hedging volatility risk of index and stock options] is one of the most important uses for these contracts,' he adds. 'VIX can be considered a measure of how the market is currently pricing options. The real value for the market makers is when there are derivative instruments based on that index, it allows them to take positions to manage the risk.'

VIX options are more complicated than futures but are expected to provide a more flexible instrument for managing volatility risk. 'For example, options market makers mostly would think that 'although the professor tells me that the volatility is 21.3 per cent, the market is telling me that it is 27.6 per cent',' Figlewski says. '[If I was a market maker], I might go with the market because I am worried about what will happen to me tomorrow.

'The options will probably still be priced at 27.6 per cent, which will be the relevant number for me, even though I recognise that perhaps it is too high in terms of what actually could happen the next day. As a market maker, I am more worried about how the options will be priced tomorrow. In terms of what new information market makers can get out of the VIX, I do not think they can get any other information than what they already have.'

The market does not need a lot of trading to show that the VIX-type index is a good measure of what the implied volatilities are, which reflect the market's estimate of the true volatilities and its willingness to bear risk.

'If the market is not very deep, will we see these implied volatilities get pushed around in ways that they will become less meaningful?' Figlewski says. 'Based on the ways we have seen options traded in the US, we are less worried about the broad range of options or stocks than about specific options on individual stocks.'

It will take a while before the Hang Seng VIX and the derivative contracts, developed with VIX Index as an underlying asset, are established and everyone is comfortable with using them. 'How long it will take depends a lot on what will happen in Hong Kong's economic situation at the time of the launch. For example, when VIX options were introduced in the US in 2006, volatility was extremely low and nobody was worrying about it. To launch contracts that allow people to hedge volatility, when people do not think there is any volatility risk, it will not start off very well,' Figlewski says.

'But if the VIX options had been introduced in the fall of 2008, when there was a lot of volatility risk, then it might have been a lot more successful. The time to introduce a contract for hedging is when the risk seems very large.'

Although Hong Kong is in a low interest-rate environment, Figlewski does not think it will have much impact on the introduction of VIX. 'Interest rates are an input to option pricing,' he says. 'However, it is not a very important one for short maturity options. Most traders focus on the shorter maturity ones. Of all the things that go into the Black-Scholes option pricing model, interest rates are of the least importance. When we look at an index that is based on the implied volatilities and the volatility numbers that have been put into the formula, I do not think interest rates have much to do with that.

'To use volatility as an asset class will require an enhanced understanding of trading strategies. The simple strategy of finding a portfolio of good stocks, buying them and then waiting does not work with a volatility-type index. While stocks on average are going to go up over time, volatility does not have any trend to go up. If it has gone up, it is more likely to come down and vice versa.

'The question is timing. The trading strategies are more complicated. We will see if institutional investors end up doing much of it.'