Futures on Variance and Deviance

"Don't look back. Something might be gaining on you." -- Satchel Paige
"Want to sell more window insurance? Learn how to throw rocks." -- Howard Simons

Economic decision-making has been compared to driving at 80 miles per hour while looking solely at the rearview mirror, and we economists certainly have the results to prove it. But historic data are far more available than future data, so what else are you going to use?

Risk and uncertainty enter into this equation as well. We are no longer at risk to past events, only to future developments. But as anyone who has ever bought insurance knows, actuarial tables have to be based on past events; they live in the rearview mirror too.

The insurance industry, particularly its reinsurance segment, revels in pricing esoteric risks. The spreads are richer than those available for mundane risks, and they also present intellectual challenges greater than those associated with driving the family chariot into the garage door.

Both futures and options have insurance components, and an over-the-counter market has grown around realized price variance, so it was only a matter of time before an exchange-traded futures contract on variance arose -- in this case at the Chicago Board of Options Futures Exchange. The specifications of these futures and the methodology behind them can be found here.

Implied vs. Historic Volatility

The world of options trading is based on a market-derived assessment of future events. The standard Black-Scholes model contains five variables, four of which -- current price, strike price, time to expiration and the risk-free interest rate -- are known exactly at all times. The fifth, implied volatility, can be derived from the market price of options to allow for the model's solution.

Implied volatility and the historic variance of returns, or daily percentage price changes, measure different things -- the market's price of future uncertainty and a relative frequency distribution of events, respectively -- so we have no reason to expect them to be equal. Indeed, a long-term comparison of variance, the CBOE's new volatility index based on the S&P 500 index and Parkinson's high-low-close volatility -- a measure that incorporates intraday range as well as interday change -- shows significant differences.

Different Measures, Different Concepts

Source: Howard Simons

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