VIX and Volatility Derivatives: A Survey of Relevant Financial Instruments and Pricing Models.

Abstract

Although it is relatively difficult to predict the exact returns associated with a stock, one can compute, with a certain degree of precision, the volatility associated with the stock’s return by utilizing appropriate mathematical models. In order to account for volatility, a new metric called the Volatility Index (VIX), based on S&P 100 shares, was posited by the Chicago Board Options Exchange (CBOE). This definition was tweaked eventually to make S&P 500 shares (SPX) the basis for calculating VIX by, averaging the prices of calls and puts on SPX shares, over a wide range of strike prices, considering a time frame of 30 days. Futures and options based on the VIX eventually emerged, and have gone on to acquire a very critical role in financial markets worldwide, especially after the Global Recession. In a similar vein, the India Volatility Index (VIX), reflective of the volatility of the Nifty index options over the next 30-day period, has gradually emerged as the go-to instrument for those who wish to gauge the Indian market volatility. Riding on high VIX levels due to the upcoming Indian General Elections, weekly futures contracts based on this index were introduced in February 2014 to phenomenal demands. However, the demand for these contracts has considerably fizzled out ever since, which in turn, has precluded the annulment of any plans whatsoever regarding the incorporation of new products into the suit of volatility-based derivatives pertaining to the Indian market. Given the novel premise of volatility derivatives, wherein the volatility of the underlying asset is used as the metric for arriving at trading strategies, several financial products, viz. futures, options and ETFs (exchange traded funds) have been developed based upon the same precepts. Volatility-based products are available on exchanges as well as currencies (primarily, FX), and are acquired primarily in the form of institutional volatility derivatives, with retail derivatives coming to the fore more recently. Several OTC derivatives are also available for trading volatility with these instruments being modelled as variance swaps on indexes and individual stocks. Thus, it is quite evident that a wide vista of risk-management/hedging strategies can be implemented using these derivatives. The article primarily intends to explore some of the volatility derivatives which are currently in vogue and the reasons for them being more frequently transacted vis-a-vis other volatility derivatives. Additionally, the article wishes to explore the different pricing methods that are commonly used to price such volatility derivatives. In conclusion, the article decodes the various quantitative and qualitative facets of the India VIX, so as to eventually engender a healthy dialogue pertaining to the efficacy of India VIX-based derivatives.