An Empirical Exploration of the Cboe Volatility Index (Vix) Futures Market as a Hedge for Equity Market Investors

Abstract

Several recent articles have shown that adding a position in equity volatility, as measured by the CBOE volatility index (VIX), to an equity or hedge fund portfolio can reduce the downside risk and unattractive higher moments exposures of portfolios. However, each of these studies used the cash VIX, which is an untradeable index that measures the 30 day forward implied volatility of the price of options traded on the S&P 500 stock index. Since the VIX futures started trading at the Chicago Board Options Exchange in March 2004, we have had the opportunity to compare the pricing of the cash VIX to the VIX futures. Unfortunately, VIX futures do not closely track the calculated cash value of the VIX index, so investors will likely be disappointed in the performance of VIX as a hedge designed to reduce downside risk during sharp bear markets. It has long been known that the implied volatility of options typically exceeds the realized volatility of the underlying equity index, as options sellers charge a risk premium to options buyers. This article introduces a new risk premium, where the cost of holding stock index volatility futures exceeds the cost of the cash VIX index by over 4% per month. The large size of this volatility futures risk premium prevents the cost-effective use of VIX futures as a hedge for equity market investors.