Equity volatility is a relatively new asset class. Although volatility indexes are only available for major markets, investors see them as a diversifier. Lack of liquidity and choice is an issue.

A recent survey conducted by Edhec-Risk Institute¹ looked in part at the question of equity volatility indexes. These indexes are naturally less widely used than stock or bond indexes. Nearly 90% of respondents to the survey invest in equity and around 70% invest in bonds, while only one fifth have allocation in equity volatility.

This can be explained by the fact they are relatively new, first introduced in 1993 (Whaley 1993). However, there may also be other reasons that make investors hesitate. In addition, although few respondents invest in equity volatility, over 60% of respondents who invest in equity volatility use indexes.

Therefore, investigating in detail the views from the survey respondents is of interest, particularly when looking at equity volatility indexes. The investigation and its conclusions are divided into three sections: investment purposes, investment tools and investment issues. All the results reflect the views of respondents who have invested in equity ­volatilities.

Equity volatility indexes are designed to track the aggregate volatility of the equity market. Such indexes are usually calculated based on option prices and are often used as an indicator of investor expectations concerning future volatility.

Volatility indexes can be found on all major stock indices such as the S&P 500, Euro Stoxx 50, DAX and Dow Jones ­Industrial Average.

VIX, first introduced by Whaley (1993) for the purpose of providing a benchmark of expected short-term stock market volatility (Whaley 2008), is the most popular volatility index. The original index was designed to measure the market’s expectation of 30-day volatility implied by prices of at-the-money S&P 100 index options. The implied volatility was based on the Black-Scholes model.

Ten years later, as the change of the structure of index option trading in the US, Chicago Board Options Exchange (CBOE) together with Goldman Sachs updated the VIX methodology to reflect a new way to measure expected volatility. The new VIX is based on the S&P 500 index, the core index for US equities and estimates expected volatility by averaging the weighted prices of SPX puts and calls over a wide range of strike prices.

This volatility is model free, rather than assuming that Black-Scholes holds, the only necessary assumption is an absence of arbitrage opportunities (see Breeden and Litzenberger (1978), and it is a forward-looking measure of index volatility.

Recently, as the demand for volatility investing has increased, other exchanges have developed volatility indexes that are similar in methodology to those provided by the CBOE. For example, Euronext has developed volatility indexes on major equity indices like AEX, BEL20 and CAC40. Volatility indexes on the DAX and SMI indexes are also developed by the respective exchanges.

In general investors can invest in volatility products, usually though futures and options on the volatility indexes. In this market segment the volatility index providers, typically the options exchange, are the ones issuing investable products on these indexes. One of the biggest problems with volatility-related products is liquidity. Most of the products on these volatility indexes have low trading volume and open interest.

There are also other over-the-counter (OTC) products on volatility available such as exchange traded notes (ETNs) and variance swaps. Unlike VIX futures, variance swaps can provide long-term exposures to volatility-term structures.

Investment purposes
Starting with objectives in investing in volatility indexes, the survey found that volatility indexes could be used as a speculation tool for market volatility. For example, investors could use indexes to support their prediction on the evolution of market volatility and benefit from holding the right view. But this is not a very profound motivation to include volatility in a portfolio as this logic applies to investment products.

So behind the recent appearance of volatility products, there must be other incentives.

One advantage of investing in volatility indexes is the diversification benefits. Equity volatility indexes have natural low correlation with equity holding. In times of low returns on the equity index, the corresponding volatility index tends to rise (Szado 2009).

In addition Jacob and Rasiel (2009) show that during crisis periods, investment products tend to be highly correlated and the volatility of the market as a whole tends to go up.

One could benefit from this negative correlation between volatility indexes and other investment products by holding a long position in the equity volatility indexes. Besides the diversification benefits, equity volatility indexes are a useful tool for hedging.

Dash and Moran (2005) show that exposure to market volatility could be a good hedge to the structured products of stocks, as generally, structured products have exposure to the volatility of underlying stocks. In addition Black (2006) shows that adding a small VIX position to an investment portfolio significantly reduced the hedge fund portfolio volatility, since most hedge fund styles are exposed to equity volatility risk.

Hill and Rattray (2004) find that as equity volatility indexes would be high during market downturn, they could act as a good hedge to the increases in the transaction cost and tracking errors due to the market downturn.

The Edhec survey asked respondents what their purposes were to invest in equity volatility indexes. The survey ­discovered that most respondents used them to seek ­diversification.

This is in line with the argument that the volatility index has naturally low correlation with stocks (Szado 2009). This feature becomes more important during crisis (high correlation among investment products) (Jacob and Rasiel 2009).

In addition about half of respondents indicate they use volatility indexes to speculate on the market volatility. Around 40% of respondents share the same view as academic literature and are motivated by the hedging capability to structure products and hedge funds while a large majority (8.7%) are looking for the protection from the transaction costs.

Overall, this finding implies that the main motivation to use volatility as an instrument is to improve diversification due to the low correlation with other assets, not to hedge ­volatility risk.

Besides the purposes of investing in volatility indexes, as these indexes are new to investors, we have also examined investors’ preferred investment horizons for volatility exposures. More than half of respondents use volatility indexes to gain exposure to short-term volatility (less than three months) and 65% to medium-term volatility (more than three months but less than a year).

Volatility indexes are not a common tool to gain exposure to long-term volatility (more than one year). This finding may suggest a lack of instruments for long term volatility exposure.

Most common volatility products, such as futures and options, are traded on exchanges and usually in short term (less than one year). Variance swaps are available only on OTC markets for long-term exposures. However, the cost of swaps as well as the counterparty risk may reduce the incentives to invest in them.

Investment tools
The commonly available instruments to invest in volatility indexes are index options, index futures, ETNs which are traded on the exchange and variance swaps which are traded OTC. This is demonstrated in the preferred ways respondents used them to invest in equity volatility indexes. From the results of the survey it is clear the common ways to gain exposures to equity volatility are through index options² (52%) or index futures (44%).

ETNs or variance swaps are not so commonly used. The reason is probably the lack of liquidity for these products and also that futures and options are more regulated products with low counterparty credit risk as compared to exchange traded notes and variance swaps.

Investment issues
Like stock and bond indexes, volatility indexes have their own problems. Liquidity is the major issue which has been pointed out in most literature. There are very limited trading volumes on various equity volatility indexes, except for the VIX.

Liquidity issues would lead to challenges when investing in index-linked instruments, which may be a hurdle for practitioners when investing in volatility indexes.

Another problem which may also be linked to the liquidity issues is the lack of products. Currently available volatility indexes are associated with only large stock indexes, as building the volatility index requires a range of options with different strike prices around the current prices that mature on the same date. All these options have to be deeply and actively traded (Whaley 2008 and Figlewski 2008).

This in fact limits the wide use of volatility indexes as it is challenging to create new volatility products. Hence, respondents to the survey were asked to indicate which issues they considered the most important. The results show the average ratings received by each problem³.

Clearly, the most critical issues we have just mentioned are what concern investors the most: lack of product variety (2.44) as well as the liquidity of option market (2.44) and investable products (2.1). As building a volatility index requires the presence of a liquid option market, equity volatility indexes are not available in all countries, such as emerging markets, or in specific sectors, such as small-cap stocks (Goltz et al. 2011).

Hence, volatility indexes could not reflect volatilities in all countries or in specific sectors. This argument is also given a high level of importance (2.0) from our respondents. In addition, investors apparently agree with the criticism that the volatility extracted from the option market does not reflect the true volatility (importance of 1.88), as deriving implied volatility from the option markets could be affected by any factor impacting supply and demand in the option market that have little to do with the underlying stock or stock index returns. In addition, Jiang and Tian (2007) find evidences to show that the current estimation methodology used by CBOE underestimates the true volatility due to implementation errors.

As equity volatility is a newly introduced asset class, the market is not well developed yet as volatility indexes are only available for major markets. Investors are attracted by its interesting characteristics as a diversifier.

But the survey has revealed that the lack of liquidity and the lack of choice of indexes are the most important issues. In addition, our respondents think that volatility extracted from the option market does not reflect the true volatility of the index. All these issues are important and need to be addressed for future development of equity volatility indexes.

Head of applied research Felix Goltz and senior research engineer Lin Tang at Edhec-Risk Institute wrote this article.

Head of applied research Felix Goltz and senior research engineer Lin Tang at Edhec-Risk Institute wrote this article.

Footnotes
1 Goltz, Amenc NF and Tang, L. "Edhec-Risk European Index Survey 2011", October 2011. Edhec-Risk Institute Publication. The survey was based on responses from 104 institutional investment managers representing approximately €7 trillion ($9.7 trillion) in assets under management (AUM).
2 Index options refer to options on equity volatility indexes, not on the underlying of the volatility indexes.
3 The rating is on a scale of -1 (not important), 0 (I don't know), 1 (slightly important), 2 (important) and 3 (very important).

References
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