What is the Chicago Board Options Exchange Market Volatility Index (VIX)?

Discuss about the Risk Management Derivatives Of Chicago Board.

Chicago board options exchange market volatility index also known as VIX has been considered in the year 1993 by Robert E. Whaley who was the professor of Duke University for providing benchmark of the expected volatility of short term. As per CBOE VIX is used to measure the 30 day expected volatility related to S&P 500 index. Components of the VIX next and near term call and put options as well as quiet near generally in second and first S&P 500 index

What is Chicago Board Options Exchange’s Market Volatility Index (the VIX)? How can it be constructed and why has it become so significant for the financial markets?

VIX is the index similarly as DJIA (Dow Jones Industrial Average) which is computed based over the real time across the trading days. As marked by Whaley, (2009), the only what the difference between DJIA and VIX is that the VIX basically measures the volatility and DJIA measures the price. Volatility index has been introduced in the year 1993 having two basic purposes. First, it intends for providing benchmark of the expected market volatility for a short term period and facilitate the comparisons of past and present volatility index level with the historical levels through computing minute by minute values utilising the option prices of index.  Secondly, volatility index also things to provide the index over which the optional contracts and futures on volatility can be written. As inferred by Fernandes et al.(2014), value of the volatility lies in a fact of it being negatively correlated with returns of equity market as well as becomes increasing as the acceleration of market declines start. Due to this long exposure to the volatility can provide arising portfolio protection levels exactly at the time when the investors are in need of that particular protection mostly. As discussed by Whaley, (2000), VIX define empirical understanding and theoretical knowledge of the implied volatility which has been put into the play in the year 2004 wherever VIX futures started trading as followed in the year 2006 by creating options on VIX.

Capital has launched the exchange traded notes which track the future contracts of VIX. Development of the ETNs or exchange trade notes over VIX has some special relevance for management industry of private wealth. As observed by Pati et al.(2017), VIX index is therefore, the calculation which is designed for producing a particular measure of the constant along with 30 days anticipated volatility of US Stock Market which is derived from the real time and mid-quote prices of the S&P 500 index call as well as put options. VIX is the computed index which is not only derived depending over stock prices. Rather, as argued by Kocaarslan et al. (2017), it utilises prices of the options over S&P 500 as well as estimate the quantity of volatility of this particular options that shall be within current date as well as expiration date of option. Chicago board options exchange combines prices of several options as well as derives the aggregate volatility value which is tracked by the index. As addressed by Marini?evait? and Ražauskait?, 2015, it is quite significant that volatility index seems to be forward looking because it would measure the volatility that the investors are expecting to observe. It is merely not the backward looking index for measuring volatility which is recently realised as suggested by some of the authors. Conceptually volatility index behaves like yield of a bond to the maturity. Yield to the maturity is a discount rate which equates price of the bond with its present value of the promised payments.

How is the VIX calculated?

Original volatility index is typically based over option prices of S&P 100 index and not a self-500 index. According to Figlewski, and Frommherz, (2016), when volatility index was first introduced in 1993 OEX options intended to be much more actively traded within us which accounts for almost 75% of entire option volume of index in the year 1992. Critical to usefulness and timeliness of the implied volatility index the VIX is the only one which should be based over prices from an active and deep index option market like OEX. Second characteristic of the VIX is that it is based over prices considering only eight puts and calls of at the money index. If the courts under real-time computation of VIX are included then it would have diminished the accuracy and timeliness.

Volatility index is the implied volatility within parlance of securities industry. it is quite similar in the spirit to the yield of a bond to maturity. In order to compute the yield to maturity of the bond discount rates are searched numerically which equates present value of are bonds coupon payments which are promised and the principal repayment to current prices of bonds. As indicated by Gustafsson (2018), computation is permitted through the fact that even if bond valuation model involves several number of the terms only into maturity becomes unknown. Amount as well as timing of coupon payments as well as principal repayment is also unknown. Equating market price of the bond to the model value as well as solving for the yield thus implies that computed field towards maturity is the implied yield to the maturity.

It is quite best assessment of the market related to expected return rate over the rest of life of the bond.  Just like the bond option for stock index has the valuation model and like a bond model of valuation stock index option model of valuation consists of different parameters out of which one of them is capable for being estimated with higher degree of accuracy. As indicated by Whaley, (2000), unknown parameter can be considered as expected future volatility of the index. Again, by equity market price of the index option to the model value as well as solvent for the volatility implied volatility can be identified. It is the best assessment of the market off expected volatility related to the underlying stock of index over remaining life of option. Therefore, VIX is basically computers through minute by minute basis from implied volatility considering aneight near-the-money, second-nearby and nearby OEX series of options. Therefore, in order to compute the implied volatility index three things are required:

• optional valuation model
• observed price of option
• values of model parameters accept the volatility ones

What is the significance of the VIX?

Implied volatility are weighted in such of way that volatility index represents implied volatility of the 30 calendar day at the money OEX option.

The Chicago Board Options Exchange had created the Volatility Index to mitigate disputes related to equity and optional investments. This indexing technique determines the uncertainty of the market by doing a square root of the 30 day period returns and then reviewed in percentage points. This term expresses the volatility or the change in the market for a short period (Basher and Sadorsky, 2016). It is essential for investors to analyse the track in which the VIX is directed to manage potential risks. The investors are thoroughly warned by the analyst who devises the VIX indexing to mitigate hedging. It tells one number say for example 10 which means how volatile the equity market defined as the US S&P 500.

As supported by Bongiovanni et al. (2016), this measure explains in a snapshot how much fear limited as volatility price is in the market right now. It looks at implied volatility in equity options. The number, the higher the name is, the more worried the market is defined as price volatility of year into equity options on the S&P 500. It is one useful way to get a quick snapshot on how nervous the equity markets are based on what’s happening in derivatives market or options market and based on looking at the S&P 500 which is one of the world’s most essential equity indices. Also, Basher and Sadorsky, (2016) discussed that ETF/ETNs can also be a conservative alternative to solving hedging and risk management. Exchange Traded Funds or Exchange Traded Notes have been introduced a strategy to track VIX indexing.

There is a different issue that is related to the hedging and management of risks in the market. The factors may be the volatility of the individual stocks that the investors may be interested in. Investors generally prefer long positions in the portfolio, when the VIX is elevated instead of the S&P500. As of late, (Sonsino et al. 2017) argued that investors prefer to use the VIX indexing more to understand the volatility of the stocks. It is impossible to invest directly, therefore the security of the ETP are devised by utilising complex strategies for the future by determining the potential VIX index. This is due to the fact the contractual obligations often expire after a few years and require repeated balancing. ENT, on the other hand, is another favourite technique to trade the VIX indexing.

How can the VIX be used for hedging?

The investors are in the liberty to expose their selling stocks to obtain a target index in future. It is relatively cheap option for the investors to buy as well as sell shares and employ any trader willing to carry it out. The ETN is different than spot VIX because the best way to handle financial crisis in this situation is to revert the failing phenomenon. Frijns et al. (2016) stated that the ETN has the power to return that particular situation from the point of spot-VIX. This helps the trader to save their stocks in times of low volatility. As a hedging strategy, an investor would purchase or place choices to offset the potential loss in their stock portfolio if they expected the market to say no, whereas the worth of the investor’s equity portfolio would probably fall with the general market, the quality of choice would gain in value because the market collapsed. ETF shares or options are generally used by investors to determine risk management and hedging in the financial market.

The VIX is watched closely by investors and traders. It’s an excellent indicator and measures the volatility investors expect to check within the close to future. However, there’s abundant discussion on however specifically an investor will use the VIX, and also the degree to that its use is helpful. Many investors monitor the VIX as a result of it provides info useful regarding investor sentiment. Like several alternative sentiment indicators, investors use the VIX to spot potential market turning points. However, additionally like most sentiment indicators, the VIX isn’t smart at distinguishing actual market superiority and bottoms.

After launching, VIX is defined as one of the most popular indicators.  In spite of being or not being a precise alternate for risk, this indicator is used by the financial commentator and investors to measure the tone of attitudes of investors about the market and the most likely way of instant trading (Bongiovanni et al. 2016). VIX may be used as a means to profits and the fortification of portfolios. The VIX may be defined as a weighted index. Numerous S&P 500 options of the index are blended with the concept that the superior the premium on the mentioned options, additional indecision about the route of the marketplace. An activist demonstration is supposed of what kind of unpredictability is expected in short-term in the market.

People often use VIX as complacency. It is expected that pessimism or the consensus optimism would not result in a high VIX. Hence, VIX can be considered as an “Uncertainty Index”. A negative correlation is found between S&P 500 index and the VIX. Importantly, it is to be noted that the VIX is not technically used to measure the risk straightforwardly. Pastor forecasted volatility can be used by the investors as a substitute for the chance.  It is to be noted that risk must be enhanced consideration of as the chronological unpredictability of assortment actions, not the predictable changeable sway all along the conduit. There is a diversity of alternatives for adding in VIX into the assortments. ETNs are one of the most admired ways to trade the VIX. ETNs permit investors to purchase and vend instruments considered to imitate specific target indices. These ETNs hold a collection of rolling VIX futures contracts in the case of VIX (Frijns et al. 2016).

What are Exchange Traded Funds (ETFs) and Exchange Trade Notes (ETNs)?

Most importantly, it is to be remembered that the ETNs are different to the VIX. It is to be noted that VIX ETNs can be deviated from the spot VIX trading elevated than they should be at the time of low volatility. Jadhao and Chandra, (2017) informed that during the time of high volatility it should be lower as instability is considered as a mean-reverting occurrence. It is to be remembered that additional drawbacks can be identified due to leveraged VIX ETNs. Due to the occurrence of repositioning in the portfolio, “Volatility lag” hurts performance. In case of not coming closer to leveraged volatility ETNs to the replicating authentic performance of VIX, these items are useful only for holding short terms.

Some factors should be kept in mind of the investors. Elevated commissions should frequently be carried than even-handedness trades by features and options. A minimum margin should be maintained by the futures traders. Awareness of different treatments of tax on losses and gains is required by the investors for the contracts in future.  Both investors and time frame should have to be accurate about the track of instability. 

As a result of the European-style practice and the mean-inversion of unpredictability, Frijns et al.(2016), analysed that VIX alternatives will regularly exchange at bringing down an incentive than what appears to be fitting amid times of high instability.VIX prospects are inalienably utilised and tend to duplicate the developments of spot VIX than the ETNs better. Here once more, however, financial specialists ought to understand that the estimation of the prospects contract depends on a forward-looking evaluation of VIX. Real prospects can be lower, higher or equivalent to the spot VIX in light of that viewpoint and the measure of time left before settlement.

In this section the detailed discussion and the illustration of the exchange trade products are performing in accordance with the VIX during the year. In order to assess the performance and viability it is important to assess the tail risk insurance or an asset class returns in associated with the respective investments during the year. As discussed by Bhansali, and Harris, (2018), the typical performances of any factor are generally measured on the basis of their historical performances. Hence on the basis of the historical performances the measurement procedures can be divided into two segments. First of the section includes the measure of the typical VIX ETP which can track its benchmark index. On the other hand, the second section of the respective factor which includes the measurement reading the benchmark can perform as an asset class (Whaley, 2013).

How can investors use the VIX for risk management?

The empirical research also shows that the most traded VIX exchange traded products in respective of their performances and price discovery along with the hedging ability and trading strategy. The VIX ETPs also trades their benchmark indices well associated to their asset management procedures. Hence, Bekaert, and Hoerova, (2014) added that the factors and ETPs are exposed to identical time decay which is high negative expected returns along with the indices. Thus the applications of these are not suitable in terms of buy and hold investment during the year. However it is also observed that these factors give rise to highly profitable trading strategies for the time being. Although the ETPs are negatively correlated with the S&P 500 the ETPs have performed poorly as a hedging tool and their inclusion in a portfolio which is based on S&P 500 will decrease the risk-adjusted portfolio regarding the associated factors performances over the period (Simon, 2017).

The empirical research suggested several factors and aspects that needs to be identified and understood in order to get the accurate understandings and implications of the ETPs in relation to the VIX. The research suggested that the VIX ETFs have grossed their highest amount of share trading in the previous accounting year. VIX ETPs are often observed to be performing differently in comparison with the VIX index. Simon(2017) further conducted researches also suggested that there exist direct relationship between the tracking errors and the time to maturity of the associated VIX futures. The research determined the fact that the shorter dated futures should be able to track and measure the VIX index better.

In this context several measurements and suggestions are also to be provided in order to accurately evaluate the suggestion provided by the empirical researches made on te factors aspects related with the VIX ETPs. In this context, Eraker and Wu, (2017) also discussed that in the previous accounting year the volatility trading have resulted their highest margins of trading and also included the highest number of share volume trading in Exchange Traded Products in relation with the CBOE Volatility Index or the VIX index in the recent history of trading. The results does not impacted with such surprises as the Brexit valuations and trading have led to several uncertainties regarding the trading in the same period. However the VIX ETPs are also traded with several complexities and potential drawbacks (Stanton, 2011).

There exist further suggestions which include several good reasons for the differences that were measured in the performances of the factors. It is mainly because the VIX ETP track VIX future rather than tracking the VIX index itself. In this context, Huck(2015) added that if the performances of the VIX futures differs from the performances of the VIX it may not essentially track the performances of the VIX (Whaley, 2013).

What are the limitations of using the VIX for investment decisions?

In addition to the above suggestion it is also to be added that the understandings of the VIX futures and its measurements may behave very differently than the index, it mainly beneficial for the researches which dug deep information and knowledge and returns.  The research also suggested that there may be several reasons for the differences in the performances.  

Short vitality strategies

It is considered as a popular investment strategy that includes the procedures and methods for riding the uncertain and recent calm of worldwide stock market which is observed to be in sudden tatters. It is called short volatility and from the year 2015 it has something of a one way bet due to the orderly rise of the worldwide qualities in the time span. However in the recent years of marketing and exchange trading it has changed a quite bit (Huck, 2015).

This is mainly a strategy that includes the procedure and operation of betting against turbulences in the stocks and equity market. This is mainly because of the time span which is around two years or more and the investors of the market have gained handsome returns and margins during the year with such trading in the market. The strategies also provided the concepts of the funds that have followed the strategically implications and as a result it has attracted massive inflows during the investing periods. The short volatility strategies mainly implies the trading and measure of the associated factors and aspects regarding the market and investing portfolio which provides suitable proportions of the profitable margins and returns to the investors and assets holder during the year in the associated market. The strategies are implicated in the short term basis mainly for a particular period of investments and thus the procedures and returns generated by the implications of the investments are known as the short volatility strategies (Whaley, 2009).

In the recent years the short volatility strategies have become much more popular comparing to other investment strategies. This is mainly because of the assets that are involved in the investment operations and related exchange traded products have resulted in rise more than $3 billion in the recent years which is considered as a record in that time span. In this context it is toe added that the measurement requires the estimation of how much money is tied up or involved in the strategies in the overall aspect.

Usage of short volatility strategies in order to create investors returns

In order to discuss and understand the factors and aspects that are associated with the investors returns in terms of applying the short term volatility strategies, there are several points and measurements which are to be identified and observed. In this context,Eraker and Wu, (2017) referred that the these points and factors of the short term volatility strategies are important in order to consider the essential and dependable factors in order to determine the accurate margins of the investors returns or the procedures of the investors returns regarding the implications of the short volatility strategies during the year. The points and the summary of the short term volatility strategies are as followed

The investors must be beware of the “derivatives of derivatives”. This is mainly important where investors are evaluating whether a given portfolio is appropriate regarding the expected returns and profitability portfolios during the year. In this context it is also to be mentioned that the market investors should be cautious regarding the understandings of the primary drivers and factors for portfolio returns (Whaley, 2013). 

The asset investors also includes the put writing strategies which can provide equity like returns over the long term period with the inclusion of lesser sensitivity into the market valuations. The strategies are also beneficial for the smaller drawdowns compared to the drawdowns of the equity markets.  The implications of the mentioned strategies are important in order to get sustained and suitable returns regarding the investments made in the stock and equity markets in relations with the short volatility strategies over the periods (Eraker and Wu, 2017).

In the history of the short term volatility strategies only two times the returns of the investment have observed to be higher than twice the investments margins. This was back in the years 1929 and 1999. However in the present market the volatility investments are no longer cheap. It is to assume that the present market and equity investors should identify and observe the put writing strategies as a suitable and accurate substitute or replacement for equities (Whaley, 2013). 

Risks of short vitality strategies regarding the creation of managers’ funds and financial markets

There exist several risks and uncertainties in the short volatility strategies implications and equity marketing of investments. In the contrast of the above it should be added an investor and market operators must know the procedures and methods that required for the accurate and suitable identification of the risks that are associated with the short volatility strategies and equity investments during the year. As supported by Anson, and Ho, (2003), the associated risks in this section are important to be identified the racism can alter and impact he net returns and profitability margins of the investments and the investors may face several hardships in the market operations. The risks are illustrated and discussed as follows

The short term volatility strategies and the equity strategies include the operations of the hedge funds which are not very liquid in comparison with other various mutual funds. The reason for lack of liquidity in the hedge funds as they are often purchased in bulk quantity and have lots of funds and is able force impact on the overall portfolios. Hence the sale of these shares is quite difficult as it may go against the larger interest portfolios of the investors (Bhansali, and Harris, 2018).

If the investors are not aware of the day to day changes in the market valuations and trends in the shares they may end up facing huge amount losses and the re-entry in the market requires huge amount of fees.

Often the investors are unable to predict the trends and changes of two stocks and end up deciding wrong investing plans and strategies which results losses in the market operations.   

The risk management procedures include several steps that require suitable identifications and understandings. These are as follows

Identify the risks

One of the important factors regarding the risk management is to identify the risks that are associated in the market. The risks may be of different kinds and the impacts of the risks may also be different from each other. In an investments market there may arose equity risks. Interest risks, strategic risks these risks are important in order to get the accurate and suitable marketing strategies investments plans for expected returns from the operations (Bardgettet al. 2016).   

Analyse the risks

The second step of the risk management operations includes the detailed analysis of the market risks for the time being. As noticed by Bardgett et al.(2016), the market risks include several factors and aspects that impact the firm and its operations in different ways. Thus, it is important for the firm to identify and understand the risks individually and they should analyse the risks factors one at time and determine the impacts that the firm can face during the year. Individual risk analysis is considered as the suitable method for accurate determinations of the impacts and losses that may arise. 

Prioritize the risks

The investors and market authorities’ needs to prioritize the risk for their own benefits as they would then analyse and understand the risks associated factors much efficiently and effectively. This may benefits the investors for accurate determinations and minimization of the risk during the year of investing activities and market operations (Anson and Ho, 2003)

Conclusion

In this study a detailed research was conducted in the volatility and market indexes. The impacts and risks associated with the factors and an aspect that affects the investing activities and marketing operations of the investors are also highlighted in the study. The study also includes factors and aspects such as the short volatility strategies, VIX ETPs, VIX futures and index which were identified and discussed in accordance to the requirements of the study.  It was concluded that he identifications and understandings of the factors are important for an investor in order maintain suitable and accurate marketing operations.

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