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ZIV: Uncertainty and Time

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Uncertainty increases with time. The more time until some expected event or future date occurs, the more time there is for something unexpected to happen. That's why, for any set of investments with fixed maturity or expiration dates, longer-dated instruments are typically priced at a premium above short-term ones. In fixed income markets, investors demand a higher premium to lock up capital for a longer period of time, since interest rates and inflation may change in the interim. In options markets, put and call sellers demand higher contract premiums - reflected in higher implied volatilities - to account for the wider possible range of movement in the underlying asset at longer durations.

One reason volatility products like CBOE Volatility Index (VIX) futures are so interesting is that they isolate vega, the sensitivity of options prices to changes in implied volatility. And like regular option vega, VIX futures do not respond to new information in a uniform way. Because a short-dated contract has less time to recover from a shock in one direction or another, it will respond in greater magnitude to new data, while a longer-dated contract will give a more muted response, pricing in more mean reversion and a greater amount of data to come.

Fig. 1. VIX Futures Delta to VIX By Maturity, 2004-2012
Source: Santander


Empirically, the change in a VIX futures contract can be measured not just as the vega change of SPX options, but also as the delta change versus the spot VIX index. Fig. 1 shows the delta of VIX futures at different maturities to spot VIX since the contracts were listed in 2004. Where the front month contract has typically exhibited about 90% of the spot VIX move on a given day, contracts with horizons of six months or more have a delta of only about 0.50.

These differences in sensitivity allow traders to adjust their exposure for different expectations and risk tolerances. We are holding a position right now in VelocityShares Daily Inverse VIX Medium Term ETN (ZIV), for example, because shorting VIX futures at a medium horizon provides the positive returns associated with being short volatility without a lot of the whipsaws that occur in the short-term part of the curve.

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