Investment Strategies with VIX and VSTOXX
Silvia Stanescu
Radu Tunaru
Kent Business School,
Kent Business School,
University of Kent, Canterbury,
University of Kent, Canterbury
CT2 7PE, s.stanescu@kent.ac.uk
CT2 7PE, r.tunaru@kent.ac.uk
Abstract
VIX and VSTOXX derivatives have been the story of success in terms of product innovation
over the last five years. In this paper we use historical data on S&P500 and EURO STOXX 50,
VIX and VSTOXX, and VIX and VSTOXX Futures to reveal linkages between these important
series that can be used by equity investors to generate alpha and protect their investments during
turbulent times. We consider for comparative performance purposes investment portfolios in
U.S. and EU zone and also a long-short cross border portfolio. The econometric analysis is
spanned by a battery of GARCH models from which we have selected the GARCH (1,1), the
EGARCH and the GJR model as the best models for our data. Overall, investors with EURO
STOXX 50 exposure can improve greatly the performance of their portfolio by adding
VSTOXX futures.
1
Investment Strategies with VIX and VSTOXX
1.
Introduction
1.1 Background
“The CBOE Volatility Index (VIX) is a key measure of market expectations of near-term
volatility conveyed by S&P500 stock index option prices. Since its introduction in 1993, VIX has
been considered by many to be the world’s premier barometer of investor sentiment and market
volatility.” – Website of CBOE
Likewise, the VSTOXX index is also a volatility index, based on the expected volatility implied
by EURO STOXX 50 options. There are 12 VSTOXX rolling indices with maturities equal to
30, 60, 90, 120, 150, 180, 210, 240, 270, 300, 330 and 360 days to expiration. The calculation is
done via linear interpolation of the two nearest subindices. Each of the 8 sub-indices per option
expiry (1, 2, 3, 6, 9, 12, 18 and 24 months) is determined based on the square-root of the implied
variance.
The main attraction of the VIX and VSTOXX products lies in the negative correlation of these
volatility indices with the corresponding equity market indices, usually explained by the leverage
effect1. The evolution of S&P500 and VIX illustrated in Figure 1 and, respectively of EURO
STOXX 50 and VSTOXX in Figure 2 seems to support the idea of a negative correlation,
implying that adding VIX and VSTOXX positions (via futures contracts) would help in reducing
the risk of diversified portfolios. This connection helped the growth of the volatility derivatives
market to the extent that many investors perceive VIX and VSTOXX as an asset class of its
own.
The two graphs also indicate that there is a shock event in the equity space every time the
volatility index crosses the corresponding equity index. One could then differentiate between the
usual market jumps in volatility due to changes in policy, board announcements and takeover
Any fall in equity prices leads to an increase in the company’s leverage, which in turn increases the risk
posed to equity holders and therefore increases equity volatility. On the contrary, a decrease in equity
prices leads to reduced leverage and then the risk posed to equity holders is reduced and equity volatility
becomes smaller.
1
2
attempts, and the jumps directly related to crashes of significant importance such as Lehman
Brothers in September 2008.
Evolution of VIX and S&P500
S&P500
S&P500
VIX
1800
90
1600
80
1400
70
1200
60
1000
50
800
40
600
30
400
20
200
10
0
0
Figure 1. Daily time series of S&P500 and VIX between 02-01-1990 and 01-03-2012.
However, a very important question is the degree of correlation that is revealed by the data.
Recall that the correlation concept that is usually invoked in this context is the Pearson linear
correlation coefficient, for which we know that a value of 1 or -1 is equivalent with a linear
relationship between the two variables. As it can be observed from Figures A1 and A2 from
Appendix B there is indeed evidence of a linear decreasing relationship for the series of
logarithmic returns of the equity index and the corresponding volatility index but the gradient of
the line fitted to the historical data is not -1. It is also clear that the daily returns for both equity
indexes are between -10% and 10% whereas the returns for the volatility indexes are roughly
speaking between -30% and 40% for VIX, and between -20% and 35% for VSTOXX.
3
Evolution of VSTOXX and STOXX50
STOXX 50
VSTOXX
6,000.00
STOXX 50
5,000.00
4,000.00
3,000.00
2,000.00
1,000.00
0.00
100
90
80
70
60
50
40
30
20
10
0
Figure 2. Daily time series of EURO STOXX50 and VTOXX between 04-01-1999 and 24-022012.
Including volatility positions in an investment portfolio can be done either for portfolio
diversification or for hedging purposes. The latter is true for portfolio managers that are tracking
index equity portfolios and who are short volatility. When equity markets become highly volatile
then the portfolio tracking error and the rebalancing costs increase but using volatility futures
helps to hedge against these frictional costs. At the other extreme, the volatility futures contracts
offer a direct play on the vega with no delta involved. Hence, speculative directional positions
can be taken via VIX and VSTOXX futures. An interesting trading strategy is based on the
correlation between the VSTOXX and VIX. A fund manager may buy be long VSTOXX
volatility and short VIX volatility. A similar idea is to trade on the basis between VIX and
VSTOXX, given the historical evolution between the two.
The body of this paper is structured as follows: the following two sub-sections describe in some
detail the VIX and VIX futures contracts and VSTOXX and VSTOXX futures contracts,
respectively. Section 2 reviews the existing literature on volatility indices, while Sections 3 and 4
focus on data, methodology and empirical results. In Section 5 some investment strategies based
4
on the findings in this paper are implemented and discussed. The final section puts forth a
number of recommendations and conclusions.
1.2 VIX and VIX Futures
The VIX index has been introduced by Whaley (1993) and the methodology was further revised
in 2003. This index measures the market’s implied view of future volatility of the equity S&P500
index, given by the current S&P 500 stock index option prices2. When constructing the VIX, the
put and call options are near- and next-term, usually in the first and second S&P500 contract
months. “Near-term” options must have at least one week to maturity. This condition is
imposed in order to minimize pricing anomalies that might appear close to expiration. When this
condition is violated VIX “rolls” to the second and third S&P500 contract months3.
It is important to realize that the VIX is a measure of expected future volatility but it also
incorporates the uncertainty on the market triggered by various bank crashes and crises. In
Figure 3 we show the VIX levels versus the contemporaneous realized volatility on the S&P500
index. Simon (2003) argued that market participants tend to consider extreme values of VIX as
trading signals. Looking at the peaks of the realized variance, VIX is always under, predicting
that the realized levels of volatility during market turbulence were unsustainable. Although the
above example suggest that VIX is an accurate predictor of falling volatility, a more thorough
analysis is needed in order to draw such an important conclusion.
Considering the evolution of the VIX index depicted in Figure 3 it can be seen that it was
relatively stable in the early 1990s, but started to be “volatile” from the last quarter of 1997 to
the first quarter of 2003. Another clear milestone was the end of the year 2007 associated with
the burst of the subprime crisis leading to spikes in the values of the VIX. The spikes in the time
series of the VIX can be pinpointed to the Iraq war in early 1991, the Asian financial crisis of late
2
The CBOE changed the composition of the VIX on September 22, 2003. For the period January 2,
1986, to September 19, 2003, the VIX was calculated from S&P 100 index option prices. From
September 22, 2003, the calculation of VIX has been changed to S&P 500 index option prices. It can be
argued that, since the S&P 100 and S&P 500 index portfolios are very similar, using the VIX history
based on S&P 100 prices until September 22, 2003 (i.e. the cleaner, more accurate historical series), and
then the VIX history based on S&P500 option prices, is an acceptable way to put together a historical
VIX time series. The current methodology is independent of a pricing model, VIX being calculated in
practice from market option prices. CBOE recalculated the VIX values under the current methodology
from January 1, 1990.
3
For example, on the second Friday in June, VIX should be determined from S&P500 options expiring
in June and July. On the following Monday, July maturity will replace June as the “near-term” and August
maturity will replace July as the “next-term.”
5
10-day realized vol
VIX
120
100
80
60
40
20
0
Figure 3. Comparison of time series of VIX, calculated under the post 2003 methodology, with
the historical 10-day realized volatility, on the same day. The period covered is 16-01-1990 and
01-03-2012.
1997, the Russian and LTCM crisis of late summer 1998, and the 9/11 terrorist attacks. The post
2007 spikes are associated with the Lehman Brothers collapse of 2008 and the emergence of the
sovereign debt problems in Euro zone in 2010.
Futures contracts on VIX have started trading on 26 March 2004 and options in February 2006.
A Mini-VIX futures contract has been launched in 2009.
1.2 VSTOXX and VSTOXX Futures
The EURO STOXX 50 Index is constructed from Blue-chip companies of sector leaders in the
Eurozone: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the
Netherlands, Portugal and Spain. The EURO STOXX 50 Volatility Index (VSTOXX) index
provides the implied volatility given by the prices of the options with corresponding maturity, on
EURO STOXX 50 Index. By design the VSTOXX index is based on the square root of implied
variance and it calibrates the volatility skew from OTM puts and calls. The VSTOXX does not
measure implied volatilities of at-the-money EURO STOXX 50 options, but the implied
variance across all options of a given time to expiry. This model has been jointly developed by
6
Goldman Sachs and Deutsche Börse such that using linear interpolation of the two nearest subindices, a rolling index of 30 days to expiration is calculated every 5 seconds using real-time
EURO STOXX50 option bid/ask quotes. The VSTOXX is calculated on the basis of eight
expiry months with a maximum time to expiry of two years4. If there are no such surrounding
sub-indices, nearest to the time to expiry of 30 days, the VSTOXX is calculated using
extrapolation, using the two nearest available indices which are as close to the time to expiry of
30 calendar days as possible. In the situation that there are no two such indices VSTOXX is
calculated by extrapolation based on the nearest available indices, which are as close to 30
calendar days as possible.
The payoff of VSTOXX futures resembles more the payoff of a volatility swap, being
determined by the difference between the realized 30 day implied volatility and the expected 30
day implied volatility at trade initiation, times the number of contracts and the monetary size of
the index multiplied (€100).
The VSTOXX Short-Term Futures Index is designed to replicate the performance of a long
position in constant-maturity one-month forward, one-month implied volatilities on the EURO
STOXX 50. Similarly, the VSTOXX Mid-Term Futures Index replicates a constant 5-month
forward, one-month implied volatility. The VSTOXX Short-Term Futures index aims to provide
a return of a long position in constant maturity one-month forward one-month implied
volatilities on the underlying EURO STOXX 50 Index. In addition, another EURO STOXX 50
Index future contract has been launched in December 2010 on the Singapore Exchange,
enabling investors to react to Asian market developments and trade the EURO STOXX 50
before the opening of the European markets. This is a quanto type contract with a value of USD
10 per index point.
The graph in Figure 4 reveals the same type of conclusion as in the VIX case, that is the levels
exhibit by the realized volatility during market turbulence are not sustainable and in the short
term volatility will decrease.
4
Apart from the VSTOXX main index (which is irrespective of a specific time to expiry), sub-indices for
each time to expiry of the EURO STOXX 50 options, ranging from one month to two years, are
calculated and distributed. For options with longer time to expire, no such sub-indices are currently
available.
7
10-day realized vol
VSTOXX
120.00
100.00
80.00
60.00
40.00
20.00
0.00
Figure 4. Comparison of time series of VSTOXX with the historical 10-day realized volatility, on
the same day. The period covered is 18-01-1999 and 24-02-2012.
2.
Literature Review
2.1 The Relationship Between Implied Volatility and the Future Realized Volatility
The question how well the implied volatility forecasts future realized volatility has been received
a great deal of attention in the financial literature, the general conclusion being that implied
volatility outperforms the known historical volatility measures, see Fleming (1995), Blair et.al.
(2001), Corrado & Miller (2005). Becker et.al. (2006), however, found that VIX is not an efficient
forecaster of future realized volatility and other historical volatility estimates can be superior to
VIX alone.
2.2 The Relationship Between Implied Volatility and Stock Returns
Whaley (2000) was among the first to point out that there is a negative statistically significant
relationship between the returns of stock and associated implied volatility indexes and moreover,
positive stock index returns correspond to declining implied volatility levels, while negative
returns correspond to increasing implied volatility levels. For the S&P 100 index, the relationship
8
is asymmetric, negative stock index returns are triggered by greater proportional changes in
implied volatility measures than are positive returns.
Carr and Wu (2006) argued that it is the S&P 500 index returns that predict future movements in
the volatility index VIX and that volatility index movements do not have predictive power on the
equity index returns. On the other hand, Cipollini and Manzini (2007), using the same
methodology as in Giot (2005) and Campbell and Shiller (1998), identified a significant
relationship between the VIX levels and the 3-months S&P 500 Index returns. This linkage is
very strong following spikes in VIX while it is weaker at lower levels of VIX. Their trading
strategy to invest in the S&P5 00 index based on the VIX signal outperforms the simple strategy
of holding long the S&P 500 index, confirming wide spread belief in investment banking.
Konstantinidi et al. (2008) discussed several models for implied volatility indexes including the
VIX showing that the directional change can be forecasted using point and interval forecasts.
The directional forecast accuracy can be improved by using GARCH models as demonstrated in
Ahoniemi (2008). Compared with various standard time series models, an ARIMA(1,1,1) model
with GARCH errors fits the historical VIX data well in this study, the directional accuracy of
forecasts being close to 60% over a five year out-of-sample period. One major point made by
Ahoniemi (2008) is that the addition of GARCH errors contributes significantly to forecast
performance while the inclusion of S&P 500 returns in the model does not improve the
directional forecasts. This is in line with Christoffersen and Diebold (2006), who demonstrate
that it is possible to predict the direction of change of returns in the presence of conditional
heteroskedasticity, even if it is not possible to predict the returns themselves.
Banerjee et al.(2007) and Giot (2005) develop models that use the VIX to predict stock market
returns. The latter investigates the link between contemporaneous relative changes in VIX and
contemporaneous S&P500 returns, but also the relationship between the current VIX levels and
the future stock index returns. Denoting VIX t the value of VIX index and by OEX t the value of
S&P100 index at time t, then rVIX ,t ln(VIX t / VIX t 1 ) and
rOEX ,t ln(OEX t / OEX t 1 ) are the
logarithmic returns of the two indexes, then Giot (2005) fitted the regression
rVIX ,t 0 Dt 0 Dt 1 rOEX ,t Dt 1 rOEX ,t Dt t
(1)
where Dt is a dummy variable that is equal to 1 (0) when rOEX ,t is negative (positive) and
Dt 1 Dt . Based on this regression Giot concluded that negative returns for the stock index
9
are associated with much greater relative changes in the implied volatility index than are positive
returns.
Whaley (2009) discussed the observed VIX spikes during market unrest. He noted that when
market volatility increases or decreases, respectively, the stock prices will fall, or rise respectively.
The relationship between the rate of change on VIX and the rate of return on the corresponding
S&P500 index (SPX) is more than one of proportionality and he argues that the change in VIX
should rise quicker when the market falls than when the market rises, in line with the leverage
argument proposed by Black. This hypothesis is tested using the following regression model
rVIX ,t 0 1rSPX ,t 2 rSPX ,t Dt t
(2)
Szado (2009) showed that adding VIX futures during the 2008 financial crisis to three base
portfolios resulted in increased returns and reduced standard deviations. It was shown in the
paper that when adding ATM VIX calls to the three base portfolios will increase portfolio
returns but the effect on standard deviation was mixed, with more extreme results, not
surprisingly given the extra leverage. Using VIX call options increased the profits during market
drops but correspondingly also increased the standard deviation. The comparative analysis of
buying S&P500 puts with the three base portfolios did not produced better results than when
adding VIX Call options. Similarly, Chen et.al. 2011 demonstrated that adding VIX futures
contracts can improve the mean-variance investment frontier so hedge fund managers for
example may be able to enhance their equity portfolio performance, as measured by the Sharpe
ratio.
2.3 The Relationship between Implied Volatility Index and Its Futures Contract
Brenner et.al (2007) showed that the term structure of VIX futures price is upward sloping while
the term structure of VIX futures volatility is downward sloping. Dash and Moran (2005)
discussed the advantages of using VIX as a companion for hedge fund portfolios.
3.
Portfolio Diversification with VIX and VSTOXX
3.1 Portfolio diversification with futures
The theoretical argument tells us that, absent any market frictions, whenever we have a hedge
instrument written on the same underlying as our original exposure and with maturity matching
our hedge horizon a perfect hedge is possible. However, we are often in a situation where proxy
10
hedges (i.e. hedges on a different, but related underlying to the original exposure) are used. This
could be for liquidity, cost or other reasons.
Preliminary Analysis - Correlations
In this subsection we compare the diversification effectiveness with VSTOXX vs. VIX-related
instruments. As the effectiveness of the hedge will depend on the correlation between the
original exposure and the hedge, we first consider the correlations between the EURO
STOXX50 and VSTOXX daily log returns and between S&P 500 and VIX returns. We expect to
find negative correlations between the returns on the two equity indices and those on their
respective volatility indices. Figure 3.1 plots the 30-day historical correlations for these two pairs
of variables, while Figure 3.2 compares the same 30-day historical correlations between EURO
STOXX 50 returns and VIX and VSTOXX returns, respectively.
0.6
STOXX50 VSTOXX
S&P 500 VIX
0.4
0.2
1E-15
-0.2
-0.4
-0.6
-0.8
-1
-1.2
Figure 3.1 30-day Historical Correlations: S&P 500 vs. VIX and EURO STOXX vs. VSTOXX
Note: The correlations are computed for the daily log returns; each correlation estimate is based on the 30 working
day sample pre-dating it.
It is easily noticeable from these two figures that while the correlations between the EURO
STOXX50 and VSTOXX are always negative, the correlations between S&P 500 and VIX are
positive for part of the sample. We note that the period under consideration is January 1999 to
11
January 2012 and we recall that for the first part of the sample (i.e. January 1999 to 19 th
September 2003) the VIX was calculated based on the implied volatility of S&P 100 options.
Therefore it is not surprising that for the period predating September 2003 the correlation
between the S&P 500 returns and VIX is not so strongly negative, since for this period the VIX
was actually based on a different index. It is worthwhile noting that for this period the VIX
would be expected to prove a less efficient diversifier for a portfolio that tracks the S&P 500
since, for the period to 22nd September 2003, the VIX calculation was based on the implied
volatility of different index. The same argument applies to the use of the VIX as diversifier for
portfolios resembling the EURO STOXX50. As it can be noticed from Figure 3.2, the 30-day
historical correlation between the EURO STOXX 50 and VIX takes positive values for some of
the sample days prior to 2006; also, while the correlation between EURO STOXX 50 and VIX is
always negative post 2006, it is less so than the correlation between EURO STOXX 50 and
VSTOXX. Moreover, the correlation between the EURO STOXX 50 and VSTOXX remains
negative throughout the entire sample. Thus, the VSTOXX volatility index appears to be a more
efficient diversifier for EURO STOXX investors that the VIX.
0.6
STOXX50 VSTOXX
STOXX50 VIX
0.4
0.2
0
-0.2
-0.4
-0.6
-0.8
-1
-1.2
Figure 3.2 30-day Historical Correlations: EURO STOXX50 vs. VSTOXX and VIX
Note: The correlations are computed for the daily log returns; each correlation estimate is based on the 30 working
day sample pre-dating it.
12
However, since the VIX and VSTOXX volatility indices are not investable instruments, in
Figures 3.3. and 3.4 we consider the correlation between the daily log returns on the equity
indices (S&P 500 and EURO STOXX 50) and the VIX and VSTOXX daily log returns. 5 The
nearest maturity futures contract is considered in both of these graphs. We note that correlations
between the two equity indices and their respective volatility index futures returns remain
negative throughout the sample periods considered; however, returns on the indices appear to be
less correlated (i.e. the absolute value of correlations is lower) with the returns on the nearest
maturity volatility index futures than with the returns on the respective volatility index.
S&P 500 VIX Futures M1
S&P 500 VIX
0
-0.2
-0.4
-0.6
-0.8
-1
-1.2
Figure 3.3 30-day Historical Correlations: S&P 500 vs. VIX and VIX Futures
Note: The correlations are computed for the daily log returns; each correlation estimate is based on the 30 working
day sample pre-dating it.
5
VIX futures were introduced in 2004 and VSTOXX futures in 2009, hence Figures 3.3 and 3.4 only plot
correlations for samples starting in 2004 and 2009, respectively.
13
STOXX VSTOXX Futures M1
STOXX VSTOXX
0
-0.2
-0.4
-0.6
-0.8
-1
-1.2
Figure 3.4 30-day Historical Correlations: EURO STOXX 50 vs. VSTOXX and VSTOXX
Futures
Note: The correlations are computed for the daily log returns; each correlation estimate is based on the 30 working
day sample pre-dating it.
Rhoads (2011) notes that using only the front month VIX futures contract in a diversified
portfolio can be sub-optimal ) in the long term (high costs, underperformance in bullish markets
and overall underperformance in the long term and suggests using the front two months
contracts. We therefore also plot in Figures 3.5 and 3.6 the correlation between the two equity
indices under consideration and the second nearest maturity contract. We note that while the
correlation between S&P 500 and the nearest maturity VIX futures was always negative, the
correlation between the equity index returns and the second maturity VIX futures takes a few
positive, albeit very small values in the first part of the sample. However, as Rhoads (2011) also
notes, this could be due to the lighter trading of the contract in its early days – post 2007 the
correlations with the second maturity futures returns are always negative. The correlations
between the daily returns on the EURO STOXX 50 index and the daily returns on the
VSTOXX (spot) and VSTOXX futures, both nearest and second nearest maturities (Figure 3.6)
remain negative throughout the entire sample.
14
S&P 500 VIX Futures M1
S&P 500 VIX
S&P 500 VIX Futures M2
0.4
0.2
0
-0.2
-0.4
-0.6
-0.8
-1
-1.2
Figure 3.5 30-day Historical correlations: S&P 500 vs. VIX and VIX futures
STOXX VSTOXX Futures M1
STOXX VSTOXX
STOXX VSTOXX Futures M2
0
-0.2
-0.4
-0.6
-0.8
-1
-1.2
Figure 3.6 30-day Historical Correlations: EURO STOXX 50 vs. VSTOXX and VSTOXX
futures
To eliminate any influences coming from approaching time to maturity, we could construct a
portfolio consisting of the two nearest maturities futures contracts, which each have dynamic
weights linked to their remaining time to maturity: the closer the maturity, the lower the weight
the respective future contract has. The fact that the dynamics of VIX and VSTOXX is not
replicated closely by their futures contracts is in line with the conclusions in Moran and Dash
(2007).
15
3.2 Portfolio performance with volatility diversification
Following Szado (2009), for each of the volatility indices (i.e. VIX and VSTOXX) we consider
the following portfolios which will be compared relative to the shocks in volatility:
1. 100% equity – we will assume that the investor holds a portfolio that tracks the S&P 500
or the EURO STOXX 50 indices, respectively.
2. 60% equity + 40% bonds, where the bond exposure will be represented by a portfolio
that resembles the Barclays US or Barclays EURO Total Return Indices, respectively
A set of summary statistics for all the components of these portfolios as well as for the hedge
instruments proposed below (i.e. VIX and VSTOXX futures) is given in Tables 3.1 and 3.2
below. For the US Sample, the data ranges from March 2004 (when the VIX futures were
introduced) to February 2012. By contrast, the European sample is shorter, since VSTOXX
futures were only introduced at the end of April 2009. The US sample is split into two subperiods: a pre-crisis period (2004-2007) and a post-crisis period (2008-2012). We also analyze the
returns of 2008 separately, as this is the period in which markets saw the most dramatic
movements. As expected the volatility of the volatility-related assets, namely VIX and VSTOXX
futures, is highest and the volatility of the bond indices is lowest; this is true for both samples
(US and Europe) and for all sub-periods considered (in the US case). The range of returns is also
widest for the volatility related assets, which exhibit both the highest maximums and the lowest
minimums, again across both samples and all sub-periods. By contrast, bonds have the narrowest
ranges of returns.
S&P500
Annualized mean return
Volatility
Min
Max
Skewness
Excess Kurtosis
subperiod 1: 2004 - 2007
Annualized mean return
Volatility
Min
Max
Skewness
Excess Kurtosis
subperiod 2: 2008-2012
Annualized mean return
Volatility
Min
Bond
Index
VIX
VIX
first
second
maturity maturity
1.36%
2.65%
79.61%
53.79%
-29.48%
-18.57%
36.02%
13.04%
0.9363
0.6234
5.6505
3.3574
2.63%
22.27%
-9.47%
2.13%
-0.2859
9.7162
5.16%
3.99%
-1.26%
0.91%
-0.0516
1.7630
7.57%
12.10%
-3.53%
2.88%
-0.3205
1.9553
4.05%
3.27%
-0.98%
0.91%
-0.0393
1.5829
3.47%
70.54%
-29.48%
36.02%
1.4064
11.9821
4.90%
45.31%
-15.38%
14.45%
0.8376
5.0127
-1.85%
28.53%
-9.47%
6.17%
4.55%
-1.26%
-0.56%
87.08%
-23.13%
0.61%
60.51%
-18.57%
16
Max
Skewness
Excess Kurtosis
crisis subperiod: 2008
Annualized mean return
Volatility
Min
Max
Skewness
Excess Kurtosis
10.96%
-0.2133
5.8829
1.33%
-0.0736
1.2839
23.57%
0.6899
2.7090
17.00%
0.5207
2.3143
-50.80%
41.41%
-9.47%
10.96%
-0.021
3.6484
5.47%
5.93%
-1.26%
1.24%
-0.1278
0.4911
65.80%
94.17%
-23.13%
23.57%
0.0069
2.8567
63.25%
60.86%
-18.57%
12.82%
0.0323
2.3229
Table 3.1 Summary Statistics of log returns series for the portfolio components of U.S. Market
Notes: The summary statistics are of the daily returns on the S&P 500 equity index, Barclays US Aggregated
total return bond index from 26h March 2009 to 17th February 2012. The standard errors are approximately
(6/T)1/2 and (24/T)1/2 for the sample skewness and excess kurtosis, respectively, where T is the sample size. The
values of the t statistic for both the sample skewness and excess kurtosis indicate that returns for most of the
assets considered follow non-normal distributions, generally leptokurtic.
Euro
STOXX
50
Annualized mean return
Volatility (annualized st dev)
Min
Max
Skewness
t-statistic Skewness
Excess Kurtosis
t-statistic Kurtosis
2.17%
25.49%
-6.54%
9.85%
0.0375
0.4036
3.0642
16.5014
Bond
Index
(EUR)
4.65%
3.22%
-0.78%
1.08%
0.4037
4.3480
3.1098
16.7469
VSTOXX VSTOXX
Futures
Futures
M1
M2
-12.85%
77.76%
-17.38%
21.22%
0.7393
7.9620
2.5495
13.7297
-9.41%
51.73%
-12.57%
12.35%
0.3868
4.1663
1.4323
7.7130
Table 3.2 Summary statistics of log returns series for the portfolio components: European
Market
Notes: The summary statistics are of the daily returns on the EURO STOXX 50 equity index, Barclays EURO
Aggregated total return bond index from 30th April 2009 to 9th February 2012. The standard errors are
approximately (6/T)1/2 and (24/T)1/2 for the sample skewness and excess kurtosis, respectively, where T is the
sample size. The values of the t statistic for both the sample skewness and excess kurtosis indicate that returns
for all the assets considered follow non-normal distributions, all of them leptokurtic.
The returns distributions are generally non-normal: with the exception of US bonds in the 2008
sub-period, all the other returns distributions exhibit positive and highly significant (t-statistics
higher than 7) values of the excess kurtosis. As expected, equity index returns are generally
negatively skewed, while volatility futures returns exhibit positive skewness.
We now turn to the construction and analysis of the volatility-diversified portfolios. Following
Szado (2009), we pre-set the portfolio weights for the volatility futures to 2.5% and then 10%.
17
We shall relax this assumption in following sections where we shall consider alternative methods
of (optimally) determining the level of these portfolio weights.
Tables 3.3 and 3.4 summarize the performance of the volatility-diversified portfolios. We assume
that the portfolios are rebalanced weekly. In order to be able to compute the Sharpe ratios
reported in these tables, we use the 3-months Treasury Bill rates (secondary markets) in place of
the risk free rate for the US portfolio. We employ the 3-month EURO LIBOR rate as the
EURO risk free rate. 6 The results in Table 3.3 demonstrate that adding VIX futures has a
beneficial effect on portfolio performance, improving mean return but most importantly
reducing the volatility. Comparing the performance of the six portfolios under investigation it is
also clear that, in normal times such as the period 2004-2007 adding VIX futures contract
improves the mean return and produces an excellent Sharpe ratio and of course improves VaR
risk measures7. Moreover, during turbulent times such as 2008-2012, there is a great benefit in
having VIX futures in the investment portfolio, the mean return staying positive and Sharpe
ratio being the best for the portfolios containing VIX futures positions. Looking at the event risk
of 2008 it can also be remarked that extreme losses can be avoided if VIX futures positions are
added.
SPX
97.5% SPX
2.5% VIX
Futures
90% SPX
10% VIX
Futures
60% SPX
40%
Bonds
58.5% SPX
39% Bonds
2.5% VIX
Futures
54 % SPX
36% Bonds
10% VIX
Futures
All sample (2004- 2012)
Annualized Mean return
5.11%
5.50%
6.76%
4.91%
5.36%
6.78%
Volatility
22.25%
20.35%
15.80%
12.92%
11.34%
8.90%
Min
-9.03%
-8.43%
-6.90%
-5.46%
-4.86%
-3.60%
Max
11.58%
10.75%
8.39%
6.72%
6.10%
4.30%
Skew
-0.0390
0.0000
0.2670
-0.1179
-0.0409
0.8430
9.9619
10.7259
12.3318
9.9720
11.3121
11.3938
Annual Sharpe ratio
17.05%
20.53%
34.44%
27.77%
35.58%
61.32%
VaR 1%(historical)
4.43%
4.04%
2.91%
2.50%
2.19%
1.55%
Excess Kurtosis
6
In Tables x-y from the Appendix we investigate the robustness of our results to changing the
assumptions. For example, in Table x we report the results obtained assuming daily rather than
rebalancing. Moreover, results reported in Tables 3.3 and 3.4 assume that the notional amount of the
futures is held in cash. An alternative would be to invest this amount in the risk free asset and post this as
margin. We refer to this case as the ‘collateralized futures’ case. We examine the impact of
collateralization in Tables x and xx from the Appendix. We note that whether or not we take into
consideration the collateralization for marking to market the futures contracts, does not have an impact
on our final conclusions.
7
Interestingly, when using daily rebalancing as shown in the appendix, during this period adding only
2.5% VIX futures leads to a better performance than when adding 10% VIX futures.
18
VaR 5% (historical)
2.13%
1.94%
1.37%
1.22%
1.03%
0.64%
8.30%
8.70%
9.91%
6.57%
7.02%
8.38%
Volatility
12.09%
10.84%
8.94%
7.22%
6.22%
6.52%
Min
-3.47%
-2.64%
-1.90%
-1.88%
-1.40%
-1.59%
subperiod 1: 2004 - 2007
Annualized Mean return
Max
2.92%
2.59%
3.64%
1.85%
1.41%
3.79%
Skew
-0.2767
-0.2321
0.7687
-0.2049
-0.1105
2.3308
1.9129
1.5462
3.7727
1.4816
0.8776
14.8792
Annual Sharpe ratio
48.37%
57.59%
83.47%
57.04%
73.40%
90.84%
VaR 1%(historical)
2.22%
2.00%
1.37%
1.22%
1.00%
0.77%
VaR 5% (historical)
1.27%
1.10%
0.78%
0.76%
0.65%
0.49%
2.21%
2.59%
3.90%
3.39%
3.85%
5.32%
Volatility
28.50%
26.15%
20.10%
16.47%
14.51%
10.61%
Min
-9.03%
-8.43%
-6.90%
-5.46%
-4.86%
-3.60%
Max
11.58%
10.75%
8.39%
6.72%
6.10%
4.30%
Skew
-0.0005
0.0324
0.2081
-0.0790
-0.0134
0.4754
XS Kurt
6.0670
6.5080
7.9647
6.2421
7.1060
8.3145
Annual Sharpe ratio
6.75%
8.81%
17.95%
18.85%
24.52%
47.45%
VaR 1%(historical)
5.24%
4.79%
3.60%
2.98%
2.68%
1.77%
VaR 5% (historical)
2.90%
2.62%
1.88%
1.61%
1.35%
0.94%
-42.23%
-39.74%
-31.95%
-24.35%
-22.07%
-14.99%
Volatility
41.37%
38.43%
30.36%
24.03%
21.61%
15.75%
Min
-9.03%
-8.43%
-6.90%
-5.46%
-4.86%
-3.60%
Max
11.58%
10.75%
8.39%
6.72%
6.10%
4.30%
Skew
0.1999
0.2116
0.2942
0.0925
0.1310
0.3818
XS Kurt
3.8773
4.0208
4.4947
3.8998
4.1829
4.9141
-104.37%
-105.89%
-108.39%
-105.29%
-106.49%
-101.22%
VaR 1%(historical)
8.24%
7.66%
6.22%
4.97%
4.47%
3.20%
VaR 5% (historical)
4.52%
4.11%
2.90%
2.59%
2.23%
1.45%
XS Kurt
subperiod 2: 2008-2012
Annualized Mean return
short crisis subperiod: 2008
Annualized Mean return
Annual Sharpe ratio
Tables 3.3: Performance of volatility-diversified US portfolios
Notes: The performance statistics are of the daily relative returns on the different portfolios. The
portfolios are weekly rebalanced, and the notional of the futures contracts is assumed to be held in
cash (no collateralization of the futures).
19
Annualized Mean return
Volatility
Min
Max
Skewness
Excess Kurtosis
Annualized Sharpe ratio
VaR 1%(historical)
VaR 5% (historical)
STOXX
97.5%
STOXX
2.5%
VSTOXX
Futures
90%
STOXX
10%
VSTOXX
Futures
60%
STOXX
40%
Bonds
5.42%
25.51%
-6.33%
10.35%
0.1616
3.3844
10.66%
4.28%
2.55%
5.97%
23.42%
-5.81%
9.43%
0.1765
3.3979
13.98%
3.83%
2.32%
7.68%
17.92%
-5.21%
6.78%
0.1912
3.4526
27.82%
2.69%
1.78%
5.02%
15.05%
-3.77%
6.48%
0.2552
3.9618
15.45%
2.65%
1.57%
58.5%
STOXX
39% Bonds
2.5%
VSTOXX
Futures
5.58%
13.28%
-3.22%
5.72%
0.3047
4.1059
21.73%
2.15%
1.36%
54 % STOXX
36% Bonds
10%
VSTOXX
Futures
7.31%
9.51%
-3.10%
3.54%
0.4004
3.9719
48.45%
1.42%
0.88%
Tables 3.4: Performance of volatility-diversified European portfolios
Notes: The performance statistics are of the daily relative returns on the different portfolios. The
portfolios are weekly rebalancing, and the notional of the futures contracts is assumed to be held
in cash (no collateralization of the futures).
A similar story follows from the results of Table 3.4, although this analysis covers only most
recent period due to the availability of VSTOXX futures contracts introduced by EUREX.
For the European case, our analysis shows that, for the period under analysis (i.e. May 2009 –
February 2012), adding volatility exposure to an equity portfolio that tracks the EURO STOXX
50 provides indeed risk diversification benefits: the volatility decreases from over 25% to under
18% (i.e. a reduction of around 30%) for a 10% exposure to VSTOXX futures (nearest
maturity). Downside risk, as measured by Value-at-Risk, computed using the historical
methodology for two different significance levels, 1% and 5%, also decreases. Moreover, the
average return also increases, from a (annualized daily) value of 5.42% to 7.68% (an increase of
40%), resulting in a very significant increase in the annualized Sharpe ratio, from less than 0.06 to
over 0.21, an almost 4-fold increase. A reduction in volatility coupled with an increase in returns
is also obtained by investing as little of 2.5% of the portfolio value in VSTOXX futures, only
that improvements are more moderate in this case.
20
180
SPX
97.5% SPX 2.5% VIX Futures
90% SPX 10% VIX Futures
60% SPX 40% Bonds
58.5% SPX 39% Bonds 2.5% VIX Futures
54 % SPX 36% Bonds 10% VIX Futures
160
140
120
100
80
60
Fig. 3.7 Comparative Performance of various portfolios based on S&P 500
EURO STOXX 50
97.5% EURO STOXX 50 2.5% VSTOXX Futures
90% EURO STOXX 50 10% VSTOXX Futures
60% EURO STOXX 50 40% Bonds
58.5% EURO STOXX 50 39% Bonds 2.5% VSTOXX Futures
54 % EURO STOXX 50 36% Bonds 10% VSTOXX Futures
140
130
120
110
100
90
80
Fig. 3.8 Comparative Performance of various portfolios based on EURO STOXX 50
21
In Figures 3.7 and 3.8 we have compared various portfolios combining equity positions, bond
positions and volatility index positions. Overall it can be seen that VSTOXX and VIX futures
contracts can help investors to preserve positive returns after unexpected shocks in the equity
markets. On the other hand, over periods of market calmness, the futures contracts are more of
a break, confirming similar analyses in Szado (2009) and Rhoads (2011).
4.
Modelling the VIX-VSTOXX difference
In this section we investigate the nature of the difference between the VIX and VSTOXX
volatility indices. If significant, we seek to exploit this difference in a trading strategy, hence we
work with futures prices on the two volatility indices rather than with their respective spot levels.
Since these are the most actively traded contracts, we employ the nearest maturity futures
contracts both for the VIX as well as for the VSTOXX. We start by testing whether this
difference is statistically significant and we then proceed to modelling the stochastic behaviour of
the difference by means of discrete-time GARCH modelling.
VIX-VSTOXX
4
2
0
-2
-4
-6
-8
-10
-12
-14
Figure 4.1 VIX-VSTOXX Futures Historical Difference
Figure 4.1 plots the daily series of differences between the VIX and the VSTOXX nearest
maturity futures prices, for a period of over 3 years, ranging from 30th April 2009 (when the
futures contracts on VSTOXX were first introduced) to the 9th February 2012, while Table 4.1
summarizes the main statistics for this series. From Figure 4.1, we can infer that the VIX22
VSTOXX futures prices difference series appears to be stationary and also characterized by
ARCH effects. Both features are confirmed by the ADF and ARCH test results, respectively (see
Table 4.1) which are significant even at the 1% level.
Mean
t stat mean
Std dev
Min
Max
Skewness
t stat skew
Excess
Kurtosis
t stat kurt
ARCH test
ADF test
-3.7769***
-48.3589
2.0649
-11.65
2.15
-0.8444***
-9.1145
0.8628***
4.6562
273.59***
-4.168378***
Table 4.1: Summary Statistics for the VIX-VSTOXX Futures Difference
Notes: The summary statistics are of the difference between the VIX and VSTOXX nearest maturity futures
prices, from 30th April 2009 to 9th February 2012. Asterisks denote significance at 10% (*), 5% (**) and
1%(***). The standard error of the sample mean is equal to the sample standard deviation, divided by the
square root of the sample size, while the standard errors are approximately (6/T)1/2 and (24/T)1/2 for the sample
skewness and excess kurtosis, respectively, where T is the sample size.
The difference between the nearest futures prices of the two volatility indices appears significant
and negative, which means that the volatility implied by the EURO STOXX 50 options was
significantly (expected to be) higher than that of S&P 500 options, at least for the period under
consideration. The series also exhibits non-normality features in the higher moments – namely
significant negative skewness and significant positive kurtosis – further advocating the use of
GARCH modelling which can (at least partially) also explain these features.
Below we shall estimate a number of models from the GARCH family in order to see which one
best captures the dynamics of the difference series; furthermore, as models from the GARCH
family also lend themselves to forecasting applications, we shall also consider the forecasts
implied by these models. A very brief description of this family of models follows.
Engle’s (1982) seminal paper introduced the class of autoregressive conditional heteroskedastic
(ARCH) models, which Bollerslev (1986) generalized into GARCH. Any model pertaining to this
class of models is essentially formed of two equations:
23
-
A conditional mean equation, which is a regression model describing the evolution of the
financial series under analysis;
-
A conditional variance equation, which describes the conditional variance dynamics;
A very general specification of a GARCH model is given by:
yt E ( yt t 1 ) t
t zt t
zt
D(0,1)
(3)
t f ({ t i},{ t j},{ Xt 1}i 1, j 1)
In the above set of equations, yt denotes financial time series under analysis, in our case this will
be the difference series described above; E ( yt t 1) denotes the conditional mean of this
difference, while εt is a disturbance process. {zt} is a sequence of i.i.d random variables with (zero
mean and unit variance) probability distribution D. The last equation provides an expression for
the conditional standard deviation; Xt is a vector of predetermined variables included in the
information set Ωt, available at time t.
A plethora of models have been developed in the literature following Engle and Bollerslev’s
seminal papers, many of them listed in a recent and very useful glossary compiled by Bollerselv
(2008). In order to find the most appropriate GARCH model to explain the VIX-VSTOXX
difference (which was shown above to have ARCH effects), we first focus on the specification of
the mean equation; once we arrived at an optimal model for the mean equation we consider
alternative error distributions and conditional variance specifications to see which yields the best
forecasts of the difference.
We start from the plot of the autocorrelation and partial autocorrelation functions of the
difference series (see Figures 4.2 and 4.3). These figures reveal a gradually decaying ACF and a
PACF which decays to zero much faster, taking significantly non-zero values for the first few
lags and then becoming insignificant, with the exception of very few lags.
24
0.9
ACF and PACF
0.8
0.7
AC
0.6
PAC
0.5
0.4
0.3
0.2
0.1
0
-0.1
1
3
5
7
9 11 13 15 17 19 21 23 25 27 29 31 33 35 37
-0.2
Figure 4.2 ACF and PACF for the VIX-VSTOXX Nearest Futures Difference
Autocorrelation
Partial Correlation
.|******|
.|******|
.|***** |
.|***** |
.|***** |
.|***** |
.|**** |
…
.|*** |
.|*** |
.|*** |
.|*** |
.|*** |
.|*** |
.|*** |
.|*** |
…
.|******|
.|** |
.|* |
.|* |
.|. |
.|* |
.|. |
…..
.|. |
.|. |
.|* |
.|. |
.|. |
.|. |
.|* |
.|. |
…
.|**
.|**
.|**
.|**
.|**
.|.
.|*
.|.
.|.
.|.
|
|
|
|
|
|
|
|
|
|
Lag
1
2
3
4
5
6
7
….
17
18
19
20
21
22
23
24
…
32
33
34
35
36
Figure 4.3 Significance of the ACs and PACs for the VIX-VSTOXX Nearest Futures Difference
A model from the ARMA family should be able to account for the autocorrelation in the series.
Indeed the results in Table 4.2 show that a constrained AR(4) model (with the coefficient on the
third lag constrained to be equal to zero) is the most parsimonious model that eliminates the
autocorrelation. It also minimizes the BIC criterion, all terms included in the regression (namely
the AR(1), AR(2) and AR(4) terms) are significant and the improvements in the other
25
information criteria – AIC, HQIC – as well as the log likelihood are only minimal for some of
the competing models from Table 4.2. We therefore proceed to GARCH estimation, based on a
constrained AR(4) mean equation.
Criteria\Mo
del
AR(1)
AR(2)
AR(3)
AR(4)
AIC
BIC
HQIC
Log
likelihood
3.1435
3.1566
3.146
-1095.096
3.0564
3.0760
3.0640
-1062.15
3.0502
3.0764
3.0603
-1057.48
3.0313
3.0640
3.0439
-1048.37
AR(4)
constrain
AR(3)=0
3.0285
3.0547
3.0387
-1048.41
ARMA
(1,1)
ARMA
(2,1)
ARMA
(2,2)
***
***
3.0348
3.0543
3.0423
1056.1
3
***
-
3.0279
3.0540
3.0380
1051.2
3
***
**
3.0293
3.0620
3.0420
1050.7
2
***
NO
AR(1) signif
AR(2)
signif
AR(3) signif
AR(4) signif
MA(1)
signif
MA(2)
signif
Ljung-Box
***
-
***
***
***
***
***
***
-
-
**
-
NO
***
-
***
-
***
***
**
-
-
-
-
-
-
-
NO
Autocorr
at lag 1
No
autocorr
at lag 1,
but lag 2
signif
No
autocorr
up to lag
2, but
signif at 3
No
autocorr
No
autocorr
No
autoco
rr at
1%
signif.
No
autoco
rr at
1%
signif.
No
autoco
rr at
1%
signif.
Table 4.2 ARMA model selection
Notes: AIC, BIC, HQIC stand for the Akaike, Bayesian and Hannan-Quinn information criteria. The optimal
model, according to a particular information criterion, should minimize the respective information criterion.
The log likelihood should be maximized by the optimal model. Asterisks denote significance at 10% (*), 5% (**)
and 1%(***).
The GARCH model in (3) now becomes:
yt c0 c1 yt 1 c2 yt 2 c4 yt 4 t
t zt t
zt
D(0,1)
(4)
t f ({ t i},{ t j},{ Xt 1}i 1, j 1)
where the error distribution D will be either the normal or the (standardized) Student-t.
We now turn our attention to the final equation in (4), the conditional variance equation, where
the focus of a GARCH model lies. Three different variance specifications are considered in this
paper: the classical symmetric GARCH (1, 1) of Bollerslev (1986) and two asymmetric
specifications, the exponential GARCH (EGARCH) model of Nelson (1991) and the GJR
26
model, first introduced by Glosten, Jagannathan and Runkle (1993). The choice of these
particular three versions out of the great variety of GARCH models available is not random. The
basic GARCH (1, 1) model offers the advantage of having a simple specification of the
conditional variance equation. This is especially important in a forecasting exercise. Even if more
elaborate models tend to fit better in sample, parsimonious models are preferred in prediction
because they have more degrees of freedom. Moreover, previous empirical studies have proved
that no more than a GARCH (1, 1) is needed to account for volatility clustering.8 However, in
equity markets, volatility tends to increase more following unexpectedly large negative returns
than following unexpected positive returns of the same magnitude. To capture this asymmetry in
volatility, often attributed to the “leverage effect” (i.e. a fall in the market value of a firm will
increase its degree of leverage), more than a GARCH (1, 1) is needed. Both the GJR and the
EGARCH models allow for asymmetric responses of volatility to positive and negative shocks
respectively. Hence, the final equation in (2) will, in turn, take one of the following forms:
GARCH (1,1) : t2 t21 t21
GJR : t2 t21 t21 t211( t 1 0)
EGARCH : ln( t2 ) t1 E t 1 ln( t21 ) t1
t21
t21
t21
(5)
1, if t 0
.
0, otherwise
where 1( t 0)
Since the variance is always a positive quantity, non-negativity constraints apply for GARCH(1,1)
and GJR: in both models ω>0, α, β 0; for the latter model, α+ γ 0 is also sufficient for nonnegativity. 9 One advantage of the EGARCH model is that it does not necessitate any nonnegativity constraints; Moreover, for the leverage effect to hold we would need γ>0 for the GJR
and γ<0 for the EGARCH. The coefficients of the GARCH models are estimated using the
For example, Berkowitz and O’Brien (2002) show that VaR forecasts based on a simple ARMA(1, 1)GARCH(1,1) model were at least as accurate as those produced by the complicated structural models
employed by six large commercial banks.
9 Parameter conditions that ensure that the conditional variance converges to a finite unconditional
variance are given in Table x from the appendices. We note that, for all 6 models considered, the
parameter estimates reported in Table 4.3 satisfy these convergence conditions.
8
27
technique of Maximum Likelihood (ML). 10 In the interest of clarity, the full details of the
estimated GARCH models are summarized in Appendix D, while the estimation results obtained
for alternative GARCH models are reported in Table 4.3 below.
AR(4)-N-
AR(4)-T-
AR(4)-N-
AR(4)-T-
AR(4)-N-
AR(4)-T-
GARCH(1,1)
GARCH(1,1)
GJR
GJR
EGARCH
EGARCH
Constant
-0.2951***
-0.2581***
-0.2934***
-0.3011***
-0.2819***
AR(1)
0.5837***
0.6163***
0.5758***
0.6084***
0.5835***
0.6083***
AR(2)
0.1636***
0.1627***
0.1762***
0.1711***
0.1766***
0.1712***
AR(4)
0.1701***
0.1456***
0.1562***
0.1369***
0.1599***
0.1414***
ω
0.0251***
0.0323**
0.0193***
0.0232**
-0.2042***
-0.1811***
α
0.1381***
0.1142***
0.0481**
0.0341
0.2586***
0.2277***
β
0.8437***
0.8547***
0.8910***
0.9014***
0.9753***
0.9681***
λ
-
-
0.0805**
0.0715*
-0.0325
-0.0381
df
-
7.2035***
-
7.4292***
-
7.7875***
-947.651
-936.259
-946.426
-935.283
-944.298
-934.196
Model
Log
Likelihood
0.3381***
Table 4.3 GARCH Model Estimation
Note: Asterisks denote significance at 10% (*), 5% (**) and 1%(***).
The results in Table 4.3 show that all GARCH models considered fit very well in sample. For the
symmetric models (i.e. the normal and Student-t GARCH(1,1) models) all the estimated
parameters are highly significant. Among the asymmetric specifications considered, only for the
normal GJR all the model parameters are significant. Although not reported in this table because
of lack of space, we also estimated GARCH-in-mean versions for all the models in Table 4.3 (i.e.
we added an additional regressor to the conditional mean equation, which was either the
conditional variance, or its square root or its natural logarithm). However, the GARCH-in-mean
10
Note that for the EGARCH models we actually estimated slightly restricted versions of the
t 1
ln( t21 ) t1 ; this restriction
t21
t21
t 1
.
however has no impact on the parameter estimates α, β and λ and 0 E
t21
2
specification given in (2), namely: ln( t ) 0
28
terms were insignificant for all 18 specifications that we estimated and hence results are not
reported here.
5.
Investment Strategies Based on Our Results
Knowing that the difference between the VSTOXX and VIX is significant we investigate first
the following trading strategy. We enter into a cross-country spread, long VSTOXX futures and
short VIX futures when the difference of the settlement prices for the two contracts is larger
than 3% and we unwind the first day this difference becomes less than 1%. In Figure 5.1 we
report the cumulative returns for each leg of the strategy. The profit that could have been made
is in EUR for the VSTOXX curve and in USD for the VIX curve.
VSTOXX
VIX
80.00%
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
-10.00%
Figure 5.1 Cumulative returns from long-short trading strategy using VSTOXX futures and VIX
futures with nearest maturity. Calculations are for the period 30 April 2009 to 9th February 2012.
29
The trading strategy highlighted above is more profitable for the VSTOXX leg than the VIX leg.
One explanation is given by the fact that in 2010 and 2011 the European sovereign financial
crisis led to a higher level of VSTOXX and VSTOXX derivatives in general.
A potential application of the GARCH modelling results is for the forecasting of the
VIX-VSTOXX (nearest futures price) difference which in turn can be used to inform trading
strategies. Figure 5.2 plots the series of one-step ahead forecasts obtained from a AR(4)-NormalGJR (see Appendix D, Table D.1 for the exact model specification and Table 4.3, Column 4 for
the estimation results: this is the best fitting model which also exhibits asymmetry). The model
parameters are re-estimated daily, using a rolling sample of 500 observations, with 199
observations used for out-of-sample forecasting. The results depicted in Figure 5.2 show that the
VIX-VSTOXX Futures difference remains negative for the entire forecasting period (i.e. April
2011-February 2012). This is not surprising given that during this period the European markets
have been affected by the recent European sovereign debt crisis, which had a much lesser impact
on the US market. We also note that our model correctly forecasts the sign of the difference
throughout the observation period.
Actual
Forecast
0
-2
-4
-6
-8
-10
-12
-14
Figure 5.2 One-step ahead forecasts of the VIX-VSTOXX nearest Futures Price Difference
30
Given that the VIX-VSTOXX futures price difference is negative throughout our forecasting
evaluation period (and has a significant negative mean throughout the entire sample), we now
compare the trading profit obtained for the following long-short strategies:11
1) Long the nearest maturity (M1) VSTOXX futures and short the nearest maturity VIX
futures
2) (Dynamic long-short strategy): We start the strategy long the nearest maturity VSTOXX
futures and short the nearest maturity VIX futures the first time our AR(4)-N-GJR
model forecast an increase of the spread in absolute value and unwind when the model
signals a reduction in spread.
3) A second dynamic strategy is given by a signal to trade the spread, long VSTOXX and
short VIX, when the difference between the daily spread forecast and the current spread
is greater than a given threshold. The positions are closed at the end of each day.
Forecasted change in VIX-VSTOXX futures price difference
4
3
2
1
0
-1
-2
Figure 5.3 Forecasted change in the VIX-VSTOXX nearest futures price difference
11
We ignore for the moment any FX risk or indivisibility of the futures contracts and assume that an
investor has the same exposure to both the VIX and VSTOXX, through their respective futures
contracts.
31
Note: Since the difference is negative throughout, a positive change will signify a decrease in the VIX-VSTOXX
nearest futures price difference.
For the first strategy the cumulative log-return for the VSTOXX leg was 26.14% and for the
VIX leg was -17.73%.
The performance of the second trading strategy is illustrated in Figure 5.4. The trading leg
associated with VIX provides excellent return, offsetting the performance of the VSTOXX leg.
Cumulative VSTOXX
Cumulative VIX
200.00%
150.00%
100.00%
50.00%
0.00%
-50.00%
-100.00%
Figure 5.4 Performance of dynamic trading strategy. Cumulative log-returns are calculated
for each leg of the trading strategy.
Note. Calculations are done for the period 28 April 2011 to 9 February 2012.
The graph in Figure 5.5 displays the performance of our second dynamic strategy with a
threshold equal to 0.5. This strategy seems to work much better, taking advantage of the
excellent forecast of the spread.
32
Cumulative VSTOXX
Cumulative VIX
120.00%
100.00%
80.00%
60.00%
40.00%
20.00%
0.00%
-20.00%
Figure 5.5 Performance of the second dynamic trading strategy. Every day when the
difference between the forecast spread and the current spread is greater than 0.5, a long
position in VSTOXX Futures and short position of VIX Futures is taken. These positions
are closed at the end of the day. Cumulative log-returns are calculated for each leg of the
trading strategy.
Note. Calculations are done for the period 28 April 2011 to 9 February 2012.
6. Conclusions
The negative correlation between VSTOXX and EURO STOXX 50 is quite stationary and it
fluctuates mostly between -50% and -95%. The evolution of the correlation between VIX and
S&P500 was mixed. There is also a clear discrepancy between the correlation between S&P 500
and VIX on one side and the correlation between the S&P 500 and the VIX futures with nearest
maturity. A similar conclusion can be drawn for STOXX. Moreover, it seems that the futures
with the second maturity produces a closer resemblance to the VIX (VSTOXX).
We confirm on an extended set of data for VIX and also on a new set of data for VSTOXX that
these volatility indexes predicted correctly that the contemporaneous realized high volatilities
observed in the market after market shocks such as Lehman collapse and the euro crisis in
Europe, were unsustainable and the equity markets will calm down after a short period of time.
33
The first major contribution of the paper is to use the methodology described in Szado (2009)
and demonstrate that using VIX and VSTOXX futures improves the return-risk profile of
investment portfolios, particularly during turbulent times. The benefits seem to be larger for
VSTOXX, although there is less historical data involving futures contracts.
The second major contribution of this paper is to tackle the data for U.S. and Europe with a
battery of state-of-the art GARCH models. Identifying a GARCH model that works well with
data allows investors to engage in directional trading given by the signal produced by the
GARCH model. We have identified three models that work well, the GARCH (1,1) widely
known and applied in the literature, the EGARCH and the GJR models that are capable to
capture the asymmetry behind the leverage effect in equity markets. We have shown how the
AR(4)-N-GJR model can be employed successfully to trade cross-border volatility futures.
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36
Appendices
Appendix A Descriptive Statistics
Summary Statistics of VIX (02/01/1990 until 01/03/2012 daily)
Mean
Standard Deviation
Skewness
Kurtosis
ρ1
ADF in Level
VIX CLOSE
20.557
8.249
1.949
9.763
0.982
-4.684***
VIX HIGH
21.382
9.024
2.061
10.270
0.984
-4.464***
VIX LOW
19.882
8.096
1.771
8.259
0.987
-4.334***
VIX OPEN
20.605
8.615
1.906
9.124
0.982
-4.325***
Summary Statistics of VIX Futures (26/03/2004 until 17/02/2012 daily)
Mean
Standard Deviation
Skewness
Kurtosis
ρ1
ADF in Level
ADF in First Difference
VIX
Futures
Settlement Price M1
21.608
9.895
1.696
6.366
0.990
-2.696*
-8.341***
VIX
Futures
Settlement Price M2
22.344
8.831
1.326
4.996
0.992
-2.282
-9.198***
VIX
Futures
Settlement Price M3
22.750
8.068
1.124
4.371
0.995
-2.054
-9.272***
Summary Statistics of VSTOXX (04/01/1999 until 24/02/2012 daily)
Mean
Standard Deviation
Skewness
Kurtosis
ρ1
ADF in Level
VSTOXX
26.388
8.249
1.380
5.401
0.984
-3.940***
Summary Statistics of VSTOXX Futures (30/04/2009 until 09/02/2012 daily)
Mean
Standard Deviation
Skewness
Kurtosis
ρ1
ADF in Level
ADF in First Difference
VSTOXX Futures
Close Price M1
24.478
11.014
-0.894
3.814
0.859
-2.900**
-8.830***
VSTOXX Futures
Close Price M2
24.071
11.764
-1.100
3.305
0.786
-2.988**
-13.053***
VSTOXX Futures
Close Price M3
22.429
13.136
-0.895
2.315
0.782
-2.479
-9.402***
Notes: The optimum number of lags used in the ADF test equation is based on AIC. *, **, and *** denote
significance at the 10%, 5% and 1% level respectively. ρ 1 is first order autocorrelation that is derived using the
Correlogram.
37
Appendix B Scatterplots of returns for equity and volatility indexes
Logarithmic return on S&P500
15.00%
-40.00%
10.00%
5.00%
0.00%
-20.00%
0.00%
-5.00%
20.00%
40.00%
60.00%
-10.00%
-15.00%
Logarithmic return on VIX
Figure A1. Scatter plot of pairs of logarithmic returns for VIX and S&P500 between 02-01-1990
Logarithmic return of
STOXX50
and 01-03-2012.
-30.00%
15.00%
10.00%
5.00%
0.00%
-10.00%
-5.00%
10.00%
30.00%
50.00%
70.00%
-10.00%
-15.00%
Logarithmic return of VSTOXX
Figure A2. Scatter plot of pairs of logarithmic returns for VSTOXX and EURO STOXX 50
between 04-01-1999 and 24-02-2012.
38
Appendix C Portfolio Diversification with Volatility Futures – supplementary results
C.1 VIX
Summary stats - log returns, daily rebalancing, non-zero RF rate, but no collateralization of the futures
All sample (2004- 2012)
S&P 500 S&P 500 2.5% VIX
futures
Mean return
Volatility
Min
Max
Annual Sharpe ratio
VaR 1%(historical)
VaR 5% (historical)
subperiod 1: 2004 - 2007
Mean return
Volatility
Min
Max
Annual Sharpe ratio
VaR 1%(historical)
VaR 5% (historical)
S&P 500
10% VIX
futures
S&p 500
Bonds
S&P 500
Bonds
VIX
Futures
2.5%
S&P 500
Bonds
VIX
Futures
10%
2.63%
22.27%
-9.47%
10.96%
5.90%
4.59%
2.16%
2.60%
20.47%
-8.81%
10.40%
6.27%
4.25%
1.99%
2.51%
16.03%
-7.14%
8.73%
7.41%
3.19%
1.39%
3.65%
13.02%
-5.72%
6.57%
17.86%
2.56%
1.23%
3.59%
11.51%
-5.15%
6.13%
19.71%
2.22%
1.05%
3.42%
8.96%
-3.84%
4.78%
23.40%
1.57%
0.68%
7.57%
12.10%
-3.53%
2.88%
4.21%
2.35%
1.27%
7.47%
10.86%
-2.80%
2.54%
4.78%
2.12%
1.12%
7.16%
8.86%
-1.98%
3.21%
6.23%
1.41%
0.81%
6.16%
7.23%
-1.93%
1.82%
25.26%
1.22%
0.76%
6.10%
6.23%
-1.44%
1.37%
28.99%
1.01%
0.65%
5.89%
6.34%
-1.89%
3.37%
27.40%
0.78%
0.45%
-1.85%
-1.82%
-1.72%
1.36%
1.31%
1.16%
subperiod 2: 2008-2012
Mean return
39
Volatility
Min
Max
Annual Sharpe ratio
VaR 1%(historical)
VaR 5% (historical)
short crisis subperiod: 2008
Mean return
Volatility
Min
Max
Annual Sharpe ratio
VaR 1%(historical)
VaR 5% (historical)
28.53%
-9.47%
10.96%
-7.49%
5.38%
2.92%
26.33%
-8.81%
10.40%
-8.00%
4.95%
2.70%
20.48%
-7.14%
8.73%
-9.80%
3.90%
1.90%
16.62%
-5.72%
6.57%
6.40%
3.11%
1.62%
14.76%
-5.15%
6.13%
6.91%
2.77%
1.37%
10.81%
-3.84%
4.78%
8.11%
1.84%
0.94%
-50.80%
41.41%
-9.47%
10.96%
-125%
8.60%
4.63%
-47.89%
38.70%
-8.81%
10.40%
-126%
8.05%
4.63%
-39.14%
31.11%
-7.14%
8.73%
-129%
6.62%
4.63%
-28.30%
24.36%
-5.72%
6.57%
-120%
5.16%
4.63%
-25.94%
22.10%
-5.15%
6.13%
-122%
4.69%
4.63%
-18.89%
16.40%
-3.84%
4.78%
-121%
3.40%
4.63%
Summary stats - relative returns, daily rebalancing, non-zero risk-free rate, but no
collateralization of the futures
All sample (2004- 2012)
S&P 500
S&P 500 2.5% VIX S&P 500
futures
10% VIX
futures
Mean return
Volatility
Min
Max
Annual Sharpe ratio
VaR 1%(historical)
5.11%
22.25%
-9.03%
11.58%
17.04%
4.49%
5.82%
20.44%
-8.37%
11.02%
22.03%
4.08%
7.96%
16.06%
-6.68%
9.35%
41.33%
3.06%
S&p 500
Bonds
5.16%
13.00%
-5.46%
6.95%
29.56%
2.50%
S&P 500
Bonds
VIX
Futures
2.5%
5.87%
11.49%
-4.86%
6.51%
39.63%
2.14%
S&P 500
Bonds
VIX
Futures
10%
8.01%
9.10%
-3.71%
5.18%
73.46%
1.43%
40
VaR 5% (historical)
subperiod 1: 2004 - 2007
Mean return
Volatility
Min
Max
Annual Sharpe ratio
VaR 1%(historical)
VaR 5% (historical)
subperiod 2: 2008-2012
Mean return
Volatility
Min
Max
Annual Sharpe ratio
VaR 1%(historical)
VaR 5% (historical)
short crisis subperiod: 2008
Mean return
Volatility
Min
Max
Annual Sharpe ratio
VaR 1%(historical)
VaR 5% (historical)
2.14%
1.96%
1.35%
1.22%
1.03%
0.66%
8.30%
12.09%
-3.47%
2.92%
24.97%
2.33%
1.27%
8.82%
10.86%
-2.65%
2.59%
34.79%
2.09%
1.11%
10.36%
9.03%
-1.90%
3.95%
66.93%
1.37%
0.78%
6.62%
7.23%
-1.89%
1.84%
46.58%
1.20%
0.76%
7.18%
6.23%
-1.40%
1.41%
65.98%
0.99%
0.65%
8.85%
6.63%
-1.59%
4.11%
95.94%
0.76%
0.49%
2.21%
28.50%
-9.03%
11.58%
6.74%
5.24%
2.88%
3.10%
26.28%
-8.37%
11.02%
10.70%
4.80%
2.62%
5.77%
20.46%
-6.68%
9.35%
26.81%
3.67%
1.85%
3.84%
16.60%
-5.46%
6.95%
21.37%
3.03%
1.60%
4.69%
14.73%
-4.86%
6.51%
29.86%
2.68%
1.35%
7.24%
10.88%
-3.71%
5.18%
63.88%
1.74%
0.90%
-42.23%
41.37%
-9.03%
11.58%
-104%
8.24%
4.52%
-38.41%
38.65%
-8.37%
11.02%
-101%
7.67%
4.52%
-26.98%
31.06%
-6.68%
9.35%
-90%
6.23%
4.52%
-23.08%
24.33%
-5.46%
6.95%
-98%
4.94%
4.52%
-19.75%
22.06%
-4.86%
6.51%
-94%
4.46%
4.52%
-9.75%
16.38%
-3.71%
5.18%
-65%
3.16%
4.52%
41
2008: S&P and VIX futures, daily rebalancing, portfolio weights based on diagonal-VECH multivariate GARCH model
short crisis subperiod: 2008
Mean return
Volatility
Min
Max
Annual Sharpe ratio
VaR 1%(historical)
VaR 5% (historical)
8.99%
69.02%
-13.52%
15.67%
11.64%
11.75%
8.30%
C.2 VSTOXX
Summary stats - log returns, daily rebalancing, zero RF
All sample (2009- 2012)
EURO
97.5% EURO
90%
EURO
EURO STOXX
STOXX 50
STOXX 50 2.5% EURO
STOXX
Bonds VIX
VSTOXX futures STOXX 50 Bonds
Futures 2.5%
10%
VSTOXX
futures
Mean return
2.17%
1.80%
0.67%
3.17%
2.77%
Volatility
25.49%
23.47%
18.09%
15.08%
13.36%
Min
-6.54%
-6.01%
-5.35%
-3.91%
-3.41%
Max
9.85%
9.19%
7.24%
6.34%
5.77%
Annualized Sharpe ratio
8.53%
7.66%
3.71%
20.99%
20.69%
VaR 1%(historical)
4.37%
3.96%
2.77%
2.73%
2.14%
VaR 5% (historical)
2.59%
2.35%
1.83%
1.59%
1.36%
EURO
STOXX
Bonds
VIX
Futures
10%
1.56%
9.57%
-3.19%
4.08%
16.34%
1.40%
0.91%
42
Summary stats -log returns, daily rebalancing, with non-zero risk-free rate but no
collateralization of the futures
All sample (2009- 2012)
EURO
97.5% EURO
90% EURO
EURO
STOXX
STOXX 50 2.5% STOXX 50 10% STOXX
50
VSTOXX
VSTOXX
Bonds
futures
futures
Mean return
Volatility
Min
Max
Annualized Sharpe ratio
VaR 1%(historical)
VaR 5% (historical)
2.17%
25.49%
-6.54%
9.85%
-6.80%
4.37%
2.59%
1.80%
23.47%
-6.01%
9.19%
-8.98%
3.96%
2.35%
0.67%
18.09%
-5.35%
7.24%
-17.89%
2.77%
1.83%
3.17%
15.08%
-3.91%
6.34%
-4.92%
2.73%
1.59%
Summary stats -relative returns, daily rebalancing, with non-zero risk-free rate but no
collateralization of the futures
All sample (2009- 2012)
EURO
97.5%
90% EURO
EURO
STOXX 50
EURO
STOXX 50
STOXX
STOXX 50 10% VSTOXX Bonds
2.5%
futures
VSTOXX
futures
Annualized Mean return
Volatility (annualized) St dev
Min
5.42%
25.51%
-6.33%
5.73%
23.49%
-5.81%
6.65%
18.12%
-5.21%
5.13%
15.10%
-3.79%
EURO
STOXX
Bonds VIX
Futures 2.5%
2.77%
13.36%
-3.41%
5.77%
-8.55%
2.14%
1.36%
EURO
STOXX Bonds
VIX Futures
2.5%
5.45%
13.37%
-3.25%
EURO
STOXX
Bonds
VIX
Futures
10%
1.56%
9.57%
-3.19%
4.08%
-24.48%
1.40%
0.91%
EURO
STOXX
Bonds
VIX
Futures
10%
6.39%
9.66%
-3.10%
43
Max
Annualized Sharpe ratio
VaR 1%(historical)
VaR 5% (historical)
10.35%
5.92%
4.28%
2.55%
9.71%
7.74%
3.86%
2.32%
7.81%
15.12%
2.69%
1.78%
6.64%
8.11%
2.67%
1.57%
6.10%
11.51%
2.07%
1.34%
Summary stats -relative returns, daily rebalancing, with non-zero risk-free rate, with collateralization of the
futures
All sample (2009- 2012)
EURO
97.5% EURO 90% EURO
EURO
EURO
STOXX 50
STOXX 50
STOXX 50 10% STOXX
STOXX Bonds
2.5%
VSTOXX
Bonds
VIX Futures
VSTOXX
futures
2.5%
futures
Annualized Mean return
Volatility (annualized) St dev
Min
Max
Annualized Sharpe ratio
VaR 1%(historical)
VaR 5% (historical)
5.42%
25.51%
-6.33%
10.35%
5.92%
4.28%
2.55%
5.83%
23.49%
-5.81%
9.71%
8.16%
3.86%
2.32%
7.04%
18.12%
-5.21%
7.82%
17.30%
2.69%
1.78%
5.13%
15.10%
-3.79%
6.64%
8.11%
2.67%
1.57%
5.55%
13.37%
-3.25%
6.10%
12.25%
2.07%
1.34%
4.48%
25.71%
1.38%
0.88%
EURO
STOXX
Bonds
VIX
Futures
10%
6.79%
9.66%
-3.10%
4.48%
29.79%
1.38%
0.88%
44
Appendix D: GARCH Models
Model Name
Variance Model Specification
yt c0 c1 yt 1 c2 yt 2 c4 yt 4 t
Condition for finite
unconditional variance
1
t zt t
AR(4)-N-
zt
GARCH(1,1)
N 0,1
t2 t21 t21
yt c0 c1 yt 1 c2 yt 2 c4 yt 4 t
1
t zt t
AR(4)-T-
zt
GARCH(1,1)
Student t 0,1
t2 t21 t21
yt c0 c1 yt 1 c2 yt 2 c4 yt 4 t
t zt t
AR(4)-N-GJR
zt
2
1
N 0,1
t2 t21 t21 t211( t 1 0)
1, if t 0
1( t 0)
.
0, otherwise
45
yt c0 c1 yt 1 c2 yt 2 c4 yt 4 t
t zt t
zt
AR(4)-T-GJR
2
1
Student t 0,1
t2 t21 t21 t211( t 1 0)
1, if t 0
1( t 0)
.
0, otherwise
yt c0 c1 yt 1 c2 yt 2 c4 yt 4 t
Not applicable
t zt t
(variance always
N 0,1
AR(4)-N-
zt
EGARCH
2
ln( t21 ) t 1
ln( t2 ) t 1
2
t 1
t21
yt c0 c1 yt 1 c2 yt 2 c4 yt 4 t
converges to a finite long
term mean)
0
t zt t
Student t 0,1
AR(4)-T-
zt
EGARCH
t 1
E t 1 ln( t21 ) t 1
ln( )
2
2
t 1
t 1
t21
2
t
46