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Volatility as an Asset Class: Holding VIX in a Portfolio

R. Jared DeLisle
Department of Economics and Finance
Utah State University

James S. Doran
Implied Capital

Kevin Krieger
Department of Accounting and Finance
University of West Florida

December 2014

Keywords: VIX index, S&P 500 Index, Portfolio Returns


JEL Codes: G11, G12

Acknowledgements: The authors acknowledge the helpful comments and suggestions of George Aragon,
Gurdip Bakshi, Michael Brennan, Jim Carson, Don Chance, Martijn Cremers, Sanjiv Das, Dave Humphrey,
Ehud Ronn, Keith Vorkink, David Weinbaum, Xiaoyan Zhang, and participants at Baylor University,
Florida State University and University of Colorado seminars.

Communications
Author: James S. Doran
Address: 2500 30th Street Suite 206
Boulder, CO. 80303
Tel.: (850) 644-7868 (Office)
E-mail: jdoran@impliedcapital.com

Electronic copy available at: http://ssrn.com/abstract=2534081


Volatility as an Asset Class: Holding VIX in a Portfolio
Abstract

The ability to hedge market downturns without sacrificing upside returns has long been
sought by investors. Using volatility to hedge equity returns provides a desired hedge
because of its asymmetric response to price movements. If the VIX index were directly
investable, adding VIX to an S&P 500 portfolio would result in significantly improved
performance over the buy-and-hold index portfolio. Given the inability to directly trade VIX,
however, we consider a number of positions which may be utilized to mimic VIX holdings.
We find VIX futures and the VXX exchange-traded note (ETN) do not provide an effective
hedge as they generate significant negative abnormal returns. VIX calls provide better
protection than S&P 500 puts, but still result in underperformance. Alternatively, we
deconstruct VIX to find the relevant S&P 500 options which drive VIX movement. A synthetic
VIX portfolio is then formed using S&P 500 options and this position captures returns similar
to the VIX index, resulting in outperformance of the buy and hold equity portfolio. However,
unless VIX call options are added to the portfolio of S&P 500 options, making the portfolio
still has exposure to extreme negative skewness.

Electronic copy available at: http://ssrn.com/abstract=2534081


1. INTRODUCTION

Extreme stock market downturns are the most disconcerting periods for investors

since they are risk averse, wish to limit their exposure to volatility, and seek to avoid

negatively skewed payoffs (Kumar, 2009). Significant market downturns, such as those

experienced from October, 2007 to March, 2009, resulted in massive losses for most all

investors as equity indices retreated over 50%. The anxiety of such movements even

provoked many investors to sell large portions of equity, mutual fund, and exchange-traded

fund (ETF) holdings, thus guaranteeing large losses.1 The ability to more effectively hedge

equity investments with holdings that would reduce portfolio downside risk and without

giving up upside potential could combat a considerable amount of investor unease.

While a number of assets exist with returns that are, on average, negatively correlated

with equities, these instruments may not provide the desired hedge against market

downturns since the return correlations become positive in times of distress. For example,

during the market collapse in 2008, the value of both equities and commodities fell, though

traditionally, commodities are negative beta assets.2 Bond holdings also declined in value

during the 2008 crash, as the risk in commercial borrowing increased while liquidity fell.

Many hedge funds designed to cushion losses in equity markets experienced reversals over

the 2007-2009 period. Szado (2009) documents the increased correlation of asset returns

over the crisis period above the levels seen in the 2004-2006 period, implying that as the

need for diversification grew, the ability of many assets to hedge equity holdings shrank at

the most inopportune time. Additionally, while tail oriented products like long puts did very

1Mary Pilon, “Many Bought Shares High, Sold Low”, Wall Street Journal, May 18th 2009.
2Numerous commodity indices also retreated by more than 50% of value during the equity market decline of
2007-2009 as inflation ground to a standstill and consumption of raw materials slowed.

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well in crash periods, in period of stability, such as the recent bull market from 2009-2014,

they have had significant negative performance.3 Holding volatility as an asset may make

traditional negative or counter-cyclical investments moot for hedging purposes because of

the mean-reverting nature of volatility and its negative skewed payoff.

Since the introduction of VIX, it has widely been regarded as the economy’s indicator

of risk in the equities market. As noted by Whaley (1993, 2000) , the VIX index is considered

“the investors’ fear gauge index.” An important byproduct of introducing VIX was the

newfound opportunity for investors to trade in futures, introduced in March 2004, and

options, introduced in February 2006, thus allowing investors to enter into contracts which

generate payoffs specifically related to volatility. Additionally, exchange-traded products

have been established, starting in 2009 with the iPath S&P 500 VIX Short-Term Futures ETN

(ticker: VXX), that offer a more direct way to access volatility as an investment. While it is

possible to invest in equity options and futures on the S&P 500 and construct a payoff that

would be related to the volatility of the index, a more direct investment in VIX might require

less management of the position and should provide less tracking error. Thus, we wish to

explore the performance of VIX portfolios to assess the implications of holding the VIX index

alongside the S&P 500. In part, this should reveal whether “investing” in the VIX provides an

effective hedge to long-equity positions, either through lower costs or superior returns, than

alternative hedges, such as purchasing index puts. This seems especially relevant given the

current low levels of volatility and steepness of the volatility skew. Our results show that, if

3 Refer to the performance on a put writing strategy by the Asset Consulting Group that noted total return for
put writing strategy is 1153% since 1986. This is also consistent with the findings of Litterman (2011) and
Ilmanen (2012).

2
the VIX were directly investable, holding VIX in a portfolio with S&P 500 yields positive and

significant alphas across all market cycles.

With more widespread access to market information, VIX has gained increased

exposure in recent years, particularly as it rose to rare levels during the 2008 market decline.

In the wake of increased attention, Whaley (2009) sought to clarify the meaning of VIX and

discuss its characteristics. He emphasizes that, like the S&P 500 index, the VIX index is not

directly investable. However, while it is quite simple to replicate the payoff of the S&P 500

by holding the 500 underlying stocks in the appropriate proportions (or more simply, via

investment in low-cost ETFs), it is difficult or nearly impossible to replicate VIX by holding

the underlying S&P 500 options. This is in part because VIX is constructed using the first two

monthly expiration call and put out-of-the money options, with weights that are squared.

Additionally, these weights change daily. Thus, even if a portfolio were able to hold the

correct proportions on a given day, which would require a significant investment in many

option contracts, the next day the proportions would change, and the rebalancing costs

would be prohibitive making the VIX index, viewed as an asset, practically untradeable.

The introduction of futures and options on VIX, and more recently exchange-traded

notes (ETNs), made it possible to invest in volatility, or at least to take a position on its future

direction. However, it is unclear whether using these products provides a payoff similar to

that of the index, or provides the hedge against increases in volatilities that most investors

desire. As Szado (2009) notes, exposure to VIX calls and puts, as well as VIX futures, does

not directly mimic holdings in the spot levels of VIX given that the mean-reverting nature of

the underlying are priced into the derivative values. Since volatility mean-reverts, investing

in the VIX index when it is low could be seen as likely to provide protection against volatility

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increases. Giot (2005), Dennis, Mayhew, & Stivers (2006) and DeLisle, Doran, & Peterson

(2011) document the asymmetric relationship between VIX and the S&P 500 and specifically

show that VIX increases and S&P 500 declines are more strongly correlated than VIX

decreases and S&P 500 increases. Whaley (2009) documents the mean-reverting nature of

VIX and also describes its asymmetric nature such that VIX will rise more (less) dramatically

during a stock market decline (rally). Furthermore, Simon (2003) notes the tendency of

traders to overvalue (undervalue) the equity market when volatility levels are unusually low

(high). Consistent with Daigler & Rossi (2006), it would appear that investing in VIX when

it is low not only provides a hedge against declines in the S&P 500, but will not proportionally

penalize investors when the S&P 500 increases.

A number of researchers have thus considered the possibility of hedging portfolios

with VIX-mimicking assets. Dash & Moran (2005) initially considered the ability of newly

formed VIX-based products to lower portfolio risk. Emerging possibilities then developed

for such a strategy, including the use of VIX futures, VIX options and VIX-based ETNs.

Brenner, Ou, & Zhang (2006) introduce an option on a straddle designed to hedge volatility

risk. This instrument is sensitive to volatility innovations and thus useful as a hedge.

Windcliff, Forsyth, & Vetzal (2006) consider the variations in the contract designs of

volatility derivatives and discuss the difficulties of hedging the returns with such

instruments, particularly given delta and delta-gamma hedging techniques. Black (2006) and

Moran & Dash (2007) find that adding VIX futures to a passive portfolio can significantly

reduce portfolio volatility. VIX’s quick movements during risky markets also improve the

skewness and kurtosis of the overall portfolios. Briere, Burgues, & Signora (2010) advocate

a sliding approach when hedging in which more (fewer) VIX futures contracts are held when

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VIX levels are notably lower (higher) due to the mean-reverting nature of the index. Jones

(2011) and Warren (2012) also advocate using VIX futures only in a tactical manner.

While Whaley (2013) points out that trading VIX products results in poor

performance, an important remaining question is the cost-effectiveness of using VIX and VIX-

style products as a hedging or speculative strategy. If VIX were tradable, investing in the S&P

500 and VIX, perhaps when VIX is relatively low, might provide investors with a portfolio

that will increase in value when the S&P 500 increases and which will be somewhat

protected when the S&P 500 falls. Along with looking at VIX as a complementary investment

to the S&P 500, we will look at certain levels of VIX to assess when it might be best to invest

in volatility.

We then explore the benefits of investing in VIX futures and ETNs and study whether

these products mimic the payoff to the VIX index. Since these are volatility products that are

tradable, if the payoffs do not replicate the underlying index, it may imply that a tradable

asset on volatility does not provide investors with appropriate protection, especially at the

prices required for these products. Our results show that this is the case for most VIX-based

products. These findings are contrary to those of Chen, Chung, & Ho (2011), who determine

VIX futures do enhance the performance of a portfolio of equities, and are consistent with

the warnings of Whaley (2013) against using VIX-related exchange-traded products. Next,

we examine the benefit of using VIX call options for portfolio insurance, relative to S&P 500

put options, to assess whether the payoffs to VIX options provide similar downside

protection. We find that VIX options provide a reasonable hedge, as well as capture the

positive skewness of VIX. However, while VIX options maybe cheaper, on a relative basis,

compared to S&P 500 puts, the long-term expenses are still cost-prohibitive long-term.

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Finally, we construct a low-cost portfolio that attempts to capture the increases in VIX by

exploring which S&P 500 options drive the changes in VIX. We demonstrate that, by

deconstructing VIX into the individual option components, it is possible to form a portfolio

of liquid S&P 500 options that captures the payoff to the VIX index which eludes the ETN,

future, and option contracts on VIX. This synthetic VIX position improves the hedging

prospects of otherwise passive, long-equity investors especially when VIX calls are added to

the portfolio.

The rest of the article is as follows: Section 2 presents the data and its sources, Section

3 presents the analyses of the performance of VIX and existing VIX-like assets as a hedge

against market declines. Section 4 investigates which parts of VIX make it a favorable hedge

and evaluates a low-cost portfolio constructed to mimic VIX returns. Section 5 concludes the

paper.

2. DATA & METHODOLOGY

The data for comparison of VIX-based hedging strategies is assembled from

numerous sources. The actual daily VIX levels, utilized for construction of the theoretical

strategy are taken from the CBOE’s historical website.4 The methodology for VIX

construction was amended in September, 2003, though retroactive calculation allows for

collection of data beginning in 1990. Historical S&P 500 and returns are taken from CRSP in

order to calculate the returns of positions that theoretically hedge S&P 500 holdings with

the raw VIX level. To adopt actual S&P 500 holdings, we gather price data for the SPY ETF,

4 http://www.cboe.com/micro/VIX/historical.aspx

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which mimics the performance of the S&P 500, also from CRSP. VXX ETN returns are

collected from Bloomberg.

Futures positions are used as one method for creating a VIX based portfolio. VIX

futures began trading on the CBOE futures exchange in March of 2004. The daily prices of

VIX and S&P 500 futures contracts are collected from Bloomberg, beginning with the arrival

of VIX futures. However, VIX futures with two-month expiration dates were not continuously

available until the end of 2005. Thus, we limit our analyses of the VIX futures strategy to the

time period spanning 2006-2013. A second method for assembling a tradable VIX-based

portfolio is constructed with the use of VIX options. These options began trading on the CBOE

in February, 2006, and their daily prices are also collected from Bloomberg through 2013.

Additionally, data is collected for S&P 500 index options, SPX, beginning in 1996 and

ending in 2013. SPX calls and puts are used to create the synthetic VIX position. While our

focus is on the hedging ability that VIX futures, options, and the synthetic position possess,

the hedging abilities of S&P 500 put positions are also considered for comparison purposes.

The Fama & French (1993) MKT, SMB, and HML factors and the Carhart (1997) UMD factor

are provided on Kenneth French's data library website.5 Additionally, SPX options are used

to create ATM straddles, which are typically employed as plays on volatility, and whose

returns are used as an option-related factor in evaluating the results of various strategies.

Using the returns from this strategy as an additional factor in a risk model can capture the

volatility premium that is present in many hedge fund and option based strategies.

5http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. We thank Kenneth French for


making this data available.

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TABLE I presents the summary statistics for S&P 500 and VIX returns. Panel A shows

that S&P 500 returns over the entire sample period average 70 basis points per month, while

VIX returns average 130 basis points per month. However, the standard deviation of the VIX

monthly returns is 18.83%, which is so volatile that the average VIX returns are statistically

indistinguishable from zero. Additionally, the median return is negative, highlighting the

positively skewed distribution and the mean reverting nature of volatility.

[---Insert TABLE I---]

The correlation between S&P 500 and VIX returns is -0.65, demonstrating a strong

negative relation as should be expected. Panel B limits the sample to months in which S&P

500 returns are positive. Limiting the sample in this manner yields average S&P 500 and VIX

returns of 3.22% and -6.52% per month, respectively. The correlation between S&P 500 and

VIX returns during these months is -0.282. Panel C, when the sample is limited to months

where S&P 500 returns are negative, shows that the average S&P 500 and VIX returns are -

3.61% and 14.66% per month, respectively. The return correlation for these months is -

0.531. When separating the returns into up and down periods, mean returns for both the

S&P 500 and VIX are significantly different from zero, highlighting the importance of

differing market conditions. More interestingly, the absolute value of the mean S&P 500

returns is similar for up and down market conditions, while the positive mean VIX returns

are twice as large during periods of negative S&P 500 movement as the negative mean VIX

returns in periods of positive S&P 500 returns. This result highlights the asymmetric relation

8
between S&P 500 returns and VIX returns and may be indicative of the potential for using

volatility as a hedging instrument against S&P 500 losses.

Panel D breaks the sample into months where VIX and the S&P 500 have different

monthly signed returns, and month where the signed returns are the same. Almost 75% of

the sample has months when the VIX and S&P 500 have different signed returns, with 46%

of those when the S&P 500 is up and VIX is down. Just over 17% of the sample has months

when both VIX and the S&P are up, which is not unreasonable since large positive

movements can result is increases in short-term volatility.6 The 8% of observations when

volatility falls while the S&P 500 falls is unusual, but reflects that volatility and returns are

not always negatively correlated.

In order to construct a proper hedge ratio for the inclusion of VIX in a portfolio

consisting of the S&P 500, we first need to estimate how VIX and the S&P 500 move together.

Considering the potential for a non-linear relation between VIX and S&P 500, we estimate

the following regression over the entire sample period:

𝑟𝑉𝐼𝑋,𝑡 = 𝛼 + 𝛽𝑟𝑆&𝑃500,𝑡 + 𝛾𝑟𝑆&𝑃500,𝑡 2 + ε𝑡 (1)

where 𝑟𝑉𝐼𝑋,𝑡 is the return of the VIX index on day t, 𝑟𝑆&𝑃500,𝑡 is the return of the S&P 500 on

day t, 𝛼 is a constant, and ε𝑡 is the residual on day t. Since it is well-documented that the

relation between market returns and volatility is asymmetric, we split the sample into

6This can happen because call options can be bid resulting in a steepening of the volatility curve resulting in a
volatility smile.

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positive and negative S&P 500 returns and re-estimate the regression. TABLE II presents the

estimations' results.

[Insert TABLE II]

When the full sample is used, the relation between VIX and S&P 500 is highly

significant, as a 1 % change in the S&P results in a 2.7% change in the VIX index. However,

when separating the sample into positive and negative S&P 500 returns, the relation is

clearly not symmetric. When the S&P falls 𝛽 is statistically significant at least at the 5% level,

which is not the case when the S&P rises. Using the coefficient estimates, we then calculate

the weight of VIX required in a portfolio long both VIX and S&P 500 to yield a portfolio return

of zero when the S&P 500 experiences a 5% loss. On average, over the entire time period, the

portfolio would require a weight of VIX of 22.5% (i.e. a loss of 5% in the S&P 500 would be

completely offset by an increase the VIX portion of the portfolio so that the return is 0%). We

use a 5% loss threshold since it is common for long mangers and quantitative strategies to

enact stop losses or rebalance at or around this level (Khandani & Lo, 2011).

The entire time series of data is not available to an investor at any particular point in

time, however. Therefore, each month we estimate equation (1) at the end of month t using

only the data from months t-60 to t-1. We then recalculate the VIX weight at the end of month

t that would yield a portfolio return of 0% if the S&P 500 were to fall by 5% over the next

month.

3. EFFECTIVENESS OF VIX AS A HEDGE

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3.1 VIX Index as a Theoretical Portfolio Component

Given the asymmetrical relationship between VIX and the S&P 500, we examine

whether forming portfolios using the VIX index could theoretically result in greater or less

volatile returns than simple, passive investing in the S&P 500. While it is not possible to buy

the VIX index, we nonetheless wish to examine whether theoretical holdings in VIX benefit

investors by capturing both the asymmetric relationship between VIX and the S&P 500 as

well as the mean reversion in volatility. By doing so, we establish a best-case scenario by

which to evaluate the performance of VIX-like assets as a supplement to typical passive

investing.

In TABLE III, we present mean monthly returns and the CAPM alpha and beta which

result from the regression of monthly portfolio returns on the value-weighted monthly

market return. We also show the Carhart (1997) 4-factor alpha and market beta which result

from the regression of monthly returns on the three Fama & French (1993) factors (MKT,

SMB, and HML) and Carhart’s (1997) momentum factor (UMD). We additionally present the

alpha and market beta of a 5-Factor model which includes the returns on an ATM straddle in

addition to the factors in the Carhart model. The 5-factor model incorporates long at-the-

money (ATM) S&P 500 straddle returns as an additional factor in order to capture the

option-like payoff imbedded within VIX.7 We also present an OTM strangle factor to capture

additional skewness not present in the ATM options.

7ATM straddle returns have been used by Coval & Shumway (2001) and Broadie, Chernov, & Johannes
(2009) to help explain option, or non-normal returns. We follow a methodology to construct the factor similar
to Broadie, Chernov, & Johannes (2009) who use a ratio of 1:1 long puts and calls that holds the next month
expiration and rolls over each contract at the end of the month to the following expiration. For example, at the
end of January 2008, a call and a put are identified that are closest to ATM and expire in March 2008. These
two options are purchased at the ask price at the end of January. These options are then sold at the bid price
at the end of February and new ATM options are purchased with April expiration dates.

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Option-based plays on volatility produce returns distinct from equity-based

strategies (see Coval & Shumway, 2001; Broadie et al., 2009), and including the ATM straddle

factor in the explanatory model delineates the proposed VIX strategies' abnormal returns

from those of common equity- and option-based returns. A long ATM straddle position pays

off symmetrically about the strike price when the underlying experiences high volatility (i.e.

both highly positive and highly negative returns increase realized volatility). A variance

swap (a forward contract where the settlement is the notional value multiplied by the

difference in the realized variance and the variance strike) also pays off when realized

volatility is high, but these contracts are strictly over-the-counter products.8 Constructing an

ATM straddle or OTM strangle, on the other hand, can be easily done in option exchange

markets. For this reason, the ATM straddle is more appealing from a general investor's

standpoint. Thus, given similar payouts between ATM straddles and variance swaps, ATM

straddle returns provide a natural factor to control for option-like payoffs that depend on

high realized volatility.

All positions presented in table III are long in the S&P 500 but utilize VIX as a hedge

via the ratios calculated from the parameters estimated in equation (1). The theoretical VIX

hedge results are shown in Panel A. In addition to showing the performance of portfolios that

constantly hedge with VIX, we consider another alternative based on the mean-reverting

nature of VIX. The historical mean for the VIX index is roughly 20%, which corresponds to

the historical average of volatility for market returns of 17.8%. Along with examining the

mean, we also examine plus one and two standard deviations, and minus one standard

deviation based on the distribution of volatility. Therefore, a “threshold” strategy of buying

8 See Carr & Wu (2009) for details on synthesizing and pricing variance swaps.

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the VIX index when it sinks below a certain level may hedge against future decreases in the

S&P 500 without the expense of constantly maintaining the hedge. Thus, along with the basic

or “no threshold” case, we present results for portfolios which purchase VIX or VIX-like

assets only when the VIX is below the thresholds of 12.51, 20.2, 27.89, and 35.35 at the

beginning of a one-month period.

[Insert TABLE III]

The results in panel A of TABLE III show that VIX theoretically serves as an effective

hedge to holdings in the S&P 500. Using no threshold, a portfolio that holds 20% VIX results

in a monthly alpha of 83 basis points, and is significant at the 1% level. This alpha remains

significant controlling for CAPM, Fama-French, and option based factors, and is in excess of

50 basis points a month. In addition, CAPM, 4-factor and 5-factor betas decline substantially

from 1 when portfolios are hedged with theoretical VIX. The specific investing threshold

alphas increase when all thresholds are at or above the mean, with a maximum monthly

alpha of 109 basis points, for the portfolio that only invests in VIX when it is at or below one

standard deviation above the VIX historical mean. As might be expected, market betas

decline across higher thresholds for VIX levels, which highlights the dampening effect of

adding VIX to a portfolio. Funds are placed entirely in the S&P 500 on a more frequent basis

when a lower VIX threshold is invoked, and thus while hedging costs may be removed,

portfolio betas rise with lower thresholds.

Panels B and C break the periods into two sub-periods, 2006-2013, and 2009-2013.

This is done to capture the high volatility and subsequent low volatility period over the past

13
seven years, and isolate the low volatility period that has been experienced over the prior

four years. Both sub-periods show that adding VIX, especially when below the one standard

deviation threshold, results in a significant alpha even after controlling for typical factors.

The fact that some of the alphas are significant in the low volatility period is surprising since

the average level of volatility over the past four years has been significantly lower than the

long-term historical mean. This suggests that holding VIX, even when volatility is low, has

added benefits, especially for small periods of volatility shocks, such as the flash crash in May

2010 and the sovereign wealth crisis in 2011.

FIGURE 1 demonstrates the performance of portfolios which embark on the various

investment strategies hedging directly in theoretical VIX based on the ratios of TABLE II and

the thresholds given.

[Insert FIGURE 1]

Assuming an initial investment of one million dollars, portfolios which are allowed to

invest in theoretical VIX and the S&P 500 from the 1996-2013 period have final values that

are two to three times greater than investment in the S&P 500 index alone. This performance

discrepancy is even more pronounced for the 2006-2009 sub-period, which coincide with

the availability of VIX futures and VIX calls and periods of higher volatility. Unfortunately, it

is not possible to directly invest in VIX, and as such, we question whether the performance

of VIX based products will be analogous to the impressive returns offered by the theoretical

VIX hedge. It is entirely possible that the pricing and day-to-day management of these assets

may erase any theoretical improvements for investors.

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3.2 VIX-based Products

Since 2006, it has been possible for a portfolio to buy or sell cash-settled VIX futures

with expiration dates in each month of the year. Since entering into VIX futures may be a

close substitute to theoretical investment in the VIX index, we investigate whether

investment in the VIX futures actually replicates the payoff of the underlying index. Shu &

Zhang (2012) demonstrate that VIX futures have some price discovery component, but

suggest that VIX futures and VIX spots behave in a similar fashion. This lack of deviation is

important if VIX futures are going to serve as an adequate proxy for the VIX index. Panel A of

TABLE IV shows the mean returns and alphas from a portfolio that attempts to hedge S&P

500 holdings by purchasing the one-month-ahead VIX futures contracts that expire in the

following month and entering into new contracts at the end of every month. Doing so in this

fashion avoids the roll problem that surfaces when contracts approach expiration.9

The mean returns and CAPM, 4-factor and 5-factor alphas of futures-hedged S&P 500

portfolios are significant and negative. The poor performance of the futures may be due to

the term structure under which sellers of the futures incorporate a premium for the upside

risk in the index futures since, on average, VIX futures have an upward sloping term-

structure. The negative returns from the VIX futures may be representative of the negative

volatility risk premium found by Bakshi & Kapadia (2003) and others. More importantly,

since VIX itself is not investable, it is impossible to arbitrage the difference in the futures

price and the index, always leading to the upward bias in pricing. This is consistent with the

9As a VIX futures contract approaches expiration, basis risk increases and the divergence between front-
month and next-month contracts increases. Additionally, there is no way to hedge the difference between last
price and settlement price, which can cause huge variation in returns to the strategy.

15
findings is Zhang, Shu, & Brenner (2010). Holding VIX futures does impart a reduction to the

market beta, in fact resulting in a market beta insignificantly different from zero in the no

threshold case.

[Insert TABLE IV]

Portfolios which hold VIX futures substantially underperform those which hold the

theoretical VIX by a difference of 149 basis point per month using the four-factor model for

the 2006-2013 period, and more importantly, underperform the S&P 500 index itself.

Attempts to utilize the cost-savings thresholds result in even poorer portfolio performance,

as the VIX futures underperform by 183 basis points. This is, in part, driven by the fact that

VIX futures would not be purchased in the Fall of 2008, at a time when VIX levels were

historically high, but during which even higher levels of VIX were later realized. So, while VIX

futures can dampen periods of high volatility, the overall costs are prohibitive.

[Insert FIGURE 2]

FIGURE 2 highlights the expense of the VIX futures hedge using the one standard

deviation threshold starting in 2009. As can be seen, during this recent period, where VIX

started in the 40s and then retreated to the low teens, the VIX futures hedge has significantly

underperformed, resulting in an overall negative performance over the period compared to

the equity only portfolio and the theoretical VIX-hedged portfolio.

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3.3 Options as a Hedge

Unlike the VIX futures contracts, where the only choice is the expiration of the

contract, the option contracts have both time and strike dimensions. In order to construct

portfolios of S&P 500 hedged with VIX calls, at the end of each month, a one-month-ahead

VIX call is selected which is closest to at-the-money (ATM) status and has similar expiration

as the futures contracts noted in Section 3.2. Using the parameters from the earlier

regression of VIX returns on S&P 500 returns and the squared returns, we predict the return

on VIX given a 5% reduction in the S&P 500. We then use the predicted VIX return to compute

a month ahead forecasted VIX level. Using the Black & Scholes (1973) option pricing model,

we compute the predicted price of the VIX call option at the end of the next month using the

selected ATM call option’s strike price and implied volatility, as well as the predicted VIX

level as the spot price. We then compute the monthly return on the call option and calculate

the weight of the call in the portfolio that would yield a return of 0% given a 5% decrease in

the S&P 500. The weights are averaged over the last twelve months, and the average weight

is used as the portfolio weight of the VIX call in the following month.10 The actual returns of

the VIX calls are computed by buying the calls at the ask price at the end of the month and

selling the call at the end of the next month at the bid price. The portfolio returns are then

calculated using the call returns and the actual S&P 500 returns.

Portfolios of S&P 500 holdings, hedged with SPX put options, are constructed in a

similar fashion. The only differences are that 1) 5% out-of-the-money puts are used, and 2)

no regressions parameters are necessary since the relation between S&P 500 and SPX is

10Due to the shorter time series of VIX calls relative to the series of the VIX index, we compute fictional
options in 2005 using historical volatility of the VIX index. These fictional options are used in the averaging
scheme so that all options available in 2006 can be used in the portfolio analysis.

17
essentially one-to-one. Using this methodology to construct the size of the hedge results in

allocating about 2% of funds, on an annualized basis, to the options, which is similar to to the

allocation typically used to hedge equity exposure.11 In Panels B and C of TABLE III, we see

the performance of S&P 500 portfolios which are hedged with VIX calls and S&P puts,

respectively. This includes, for comparison purposes, consideration of the option hedge at

the given hedging thresholds. Using this 2% threshold makes sense for the options, versus

the 20% number for the VXX and VIX futures, because the options are designed as a tail hedge

and have higher built-in leverage while the other products are assets that do not have any

associated theta component.

We find lower market betas for the portfolios which utilize S&P puts across most of

thresholds, however, the betas of VIX-call hedged portfolios are almost zero in the no

threshold case. This suggests a significant and highly skewed response when volatility

exceeds 36. Furthermore, VIX-call hedges appear to be more cost effective as the mean

returns and alphas to such hedges are superior to the S&P put hedges, particularly in the

base, no threshold case. While the CAPM, 4-factor, and 5-factor alphas of portfolios hedged

with S&P 500 puts are significantly below zero at the 5% confidence level, in the no threshold

case, no such significance presents for the VIX-call hedged portfolios.

We see the superiority of the VIX-call hedged portfolio in FIGURE 2. While the S&P

500 put hedge, VIX call and VIX futures all underperform the S&P 500, even in the presence

of a substantial market crash during a period of overall low volatility, the VIX-call hedge

strategy has the best performance. The relative inexpensiveness of the VIX calls can be seen

early in the period as the portfolio hedged with VIX calls does not impart nearly the costs of

11
Refer to the paper “An introduction to Tail Risk Parity” by Alliance Bernstien for the cost of heding

18
the S&P put hedge. Hedging simple, passive positions like long-S&P 500 with VIX calls, rather

than S&P 500 puts, appears to be the best potential hedging strategy. It is the ability of VIX

calls to capture positive skewness that suggests they are a superior alternative with low

relative cost. What remains unclear is whether the difference in the payoffs in the two

hedging strategies is due to underpricing of VIX calls or overpricing of S&P 500 puts. There

is recent evidence that suggests skewness is priced in equity returns (Boyer, Mitton, &

Vorkink, 2010) and index option prices (Doran & Krieger, 2010). The portfolio result

suggests that the options on volatility have not incorporated corresponding positive

skewness or the increase in skewness in VIX relative to the decrease in skewness in the

index. As such, it appears that VIX calls are cheap only because of the differences in

underlying return distributions of volatility and equity instruments, not necessarily because

they are mispriced.

3.4 VXX ETN

The VXX ETN was first offered in 2009, coinciding with the increased liquidity of the

futures and options on VIX, the heightened volatility in the market, and investor demand for

a product that allowed easy access to volatility. While there is not as long a time series to

assess the performance, Panel D shows that, over the past four years (a relatively low

volatility period), the VXX ETN has significantly underperformed relative to the theoretical

VIX hedging portfolio and the S&P 500.12 This may not be surprising given the poor

performance in the futures and options on VIX, and because VXX directly invests in these

products while also having a fee structure.

12
The weights of VXX in the portfolios are identical to the weights of theoretical VIX.

19
FIGURE 2 further highlights the poor performance of a portfolio that uses VXX to

hedge volatility. The return performance is similar to that of the VIX futures hedging strategy,

but costs slightly more. This can be tied back to fees and the costs of rolling over futures

contracts each month. In summary, it appears that while VIX itself provides an excellent way

to hedging market downside without significant expense, the market products that are

available to invest in are just not viable as long-term hedging solutions.

4. REPLICATING THE VIX INDEX

4.1. Decomposing VIX

While numerous studies have analyzed the impact of the VIX, or changes in VIX, on

the returns of equity portfolios, few have considered what drives the actual changes in VIX

itself. Whaley (2009) examines the effect of changes in the S&P 500 index on VIX changes

and finds an asymmetric response to those changes. This is not surprising and is confirmed

by the results of DeLisle, Doran & Peterson (2011). However, to this point, there has been no

examination based on the actual options that cause VIX to change. Since the VIX is

constructed using only front-month and next-month closest-to-ATM, and all out-of-the

money puts and calls on the S&P 500, it is worth testing which options drive the movements

of VIX. Since there is an asymmetric response between changes in the S&P 500 and VIX, it is

highly likely that puts versus calls, ATM versus OTM, and front-month versus next-month

expiration discrepancies are responsible for the changes.

20
Before deriving an empirical specification to test the relationship between S&P 500

options and VIX changes, we briefly summarize the methodology used to calculate the VIX

Index. The specification for VIX is given by:13

2 Δ𝐾𝑖 1 𝐹 2
𝜎𝑗2 = 𝑇 ∑𝑖 𝑒 𝑅𝑇 𝑄(𝐾𝑖 ) − 𝑇 [𝐾𝑗 − 1] (2)
𝐾𝑖2 0

𝑁𝑇2 −𝑁30 𝑁30 −𝑁𝑇1 𝑁365


𝑉𝐼𝑋 = 100√{𝑇1 𝜎12 [𝑁 ] + 𝑇2 𝜎22 [𝑁 ]} (3)
𝑇2 −𝑁𝑇1 𝑇2 −𝑁𝑇1 𝑁30

where 𝐾 is the strike price of the options that are currently closest to ATM or OTM, ∆𝐾 is the

difference in strike prices, 𝑄(𝐾)is the midpoint price of the option at strike 𝐾, 𝑇1 is the

expiration of the front month option, 𝑇2 is the expiration of the next-month option, N is the

minutes to expiration and 𝐹 represents the ATM forward price of the index. Using all options

available that are closest to ATM and OTM, equation (1) constructs a 𝜎𝑗2 for both the front-

month and next-month options, while equation (2) weights the 𝜎𝑗2 to create a 30-day

measure of implied volatility.

Although both equations are straightforward to calculate and recreate the current

level of VIX, the non-linear nature makes replicating the payoff to the VIX index difficult to

accomplish. The weight on each option is a function of a root-weighted time variable, which

changes daily, making rebalancing costs prohibitive while creating indivisible option units.

However, it is possible to unwind the formula into smaller components, allowing for a test of

13A white paper available from CBOE at http://www.cboe.com/micro/vix/vixwhite.pdf shows the


construction of the VIX index.

21
the effect of each option, or the changes in the prices and moneyness of each option, on the

changes in VIX.

Taking the natural log of equation (2) removes the nonlinear term such that equation

(2) become linear and allows for a simple regression to assess the impact of the individual

options on the change in VIX. Since changes are of interest, testing the difference

𝑉𝐼𝑋𝑡
between ln(𝑉𝐼𝑋𝑡 ) − ln(𝑉𝐼𝑋𝑡−1 ), is equivalent to testing ln (𝑉𝐼𝑋 ), or the percentage change
𝑡−1

in VIX each day. The key explanatory variables to include are whether the option was a call

or a put, the time to expiration of the option, the price change, the strike price or moneyness

change, and an interaction term between these variables. It is necessary to incorporate an

interaction term, since the first term in equation (1) is multiplicative in these variables.

The following specifications are run, controlling for time variation:

𝑉𝐼𝑋𝑡
ln (𝑉𝐼𝑋 ) = 𝛼𝑡 + Δ𝑃𝜅,ϕ,τ,t + Δ𝐾𝑆𝜅,ϕ,τ,t + 𝐷𝑀𝜅,ϕ,τ,t + 𝐼𝜅,ϕ,τ,t
𝑡−1

+Δ𝑃𝜅,ϕ,τ,t ∗ 𝐶𝐷𝑡 + Δ𝐾𝑆𝜅,ϕ,τ,t ∗ 𝐶𝐷𝑡 + 𝜀𝑡 (4)

𝑉𝐼𝑋𝑡
ln (𝑉𝐼𝑋 ) = 𝛼𝑡 + Δ𝑃𝜅,ϕ,τ,t + Δ𝐾𝑆𝜅,ϕ,τ,t + 𝐷𝑀𝜅,ϕ,τ,t + 𝐼𝜅,ϕ,τ,t + 𝜀𝑡 (5)
𝑡−1

where Δ𝑃𝜅,ϕ,τ,t is the change in price of 𝜙(call/put) option with a strike of 𝐾 and maturity 𝜏

at time t. Δ𝐾𝑆 represents the change in moneyness of the option, where put moneyness is

equal to K/S and call moneyeness is equal to S/K. Thus, more positive changes bring both

definitions of moneyness closer to ATM. 𝐷𝑀 is the time to maturity of the option, and 𝐼 is the

interaction of all three variables. 𝐶𝐷 is a dummy variable equal to one if the option is a call

and zero if the option is a put. Equation (3) interacts the dummy variables with change in

price and moneyness variables to capture differences between call and put options. Equation

22
(4) examines the effect of price and moneyness changes of calls and puts separately on VIX

changes. Each specification clusters on the date to avoid overstating the t-stats. The results

are shown in TABLE V.

[---Insert TABLE V---]

Seven estimations are conducted with the first three using equation (3) and the final

four using equation (4). The first utilizes the full sample while the second (third) considers

the positive (negative) VIX changes only. The fourth and fifth estimations use only puts and

segment the sample based on whether VIX is above or below the historical mean of 20.8. The

last two estimations use only calls, again segmenting the sample based on VIX levels above

and below 20.8.

The results of the first estimation reveal that increases in option prices are positively

related to VIX changes. Specifically, if the option becomes one dollar more expensive, then

VIX will increase by 0.25% on average. However, if the option is a call, for each dollar

increase, the change in VIX is only 0.11% as the coefficient of the call dummy is -0.14. This

suggests a greater impact from put price changes than call price changes. Options that are

closer to ATM have a greater effect on VIX values, as a 0.01 increase in moneyness results in

an increase of 3.32% in VIX. Again, this is only for puts, because as call options approach ATM

status, the effect on VIX is a fall of -4.01%. This is consistent with negative correlation

between VIX and the S&P 500 since puts (calls) become more expensive as the S&P 500 falls

(increases). There is no significant relationship with the expiration of the option, although

23
the negative coefficient on DM is consistent with a negative option theta. The interaction

term is positive, as expected, but the effect on the change in VIX is small.14

The results of the second and third estimation are similar in direction for all the

coefficients, but the interpretation of the coefficients reveals interesting results. The

coefficient on Δ𝑃 is 0.141 larger and statistically different than the Δ𝑃 coefficient when VIX

is increasing versus decreasing, suggesting an asymmetric response to put price changes on

VIX changes. Also the discrepancy between put and call price changes on VIX changes is

larger when VIX is increasing. When VIX decreases, Δ𝑃 ∗ 𝐶𝐷 is insignificant, again

highlighting the importance of put price changes for VIX increases, which are highly

negatively correlated with negative S&P returns. The results of the final four estimations

further emphasize these findings. Put price changes have a greater effect on VIX changes at

all levels of VIX, relative to calls, but the effect is especially strong for VIX levels less than the

historical mean.

These results suggest that ATM put options are most responsible for driving changes

in VIX, and this appears particularly true when VIX is below its historical mean. Given these

findings, and because many investors are interested in a portfolio that hedges against

downturns in the market, holding a portfolio that is long in ATM S&P 500 puts appears to be

a natural fit. However, it has been well documented that puts are expensive.15 Thus, it is

necessary to not only go long puts, but sell either OTM puts or corresponding calls to offset

the cost. Given the results in TABLE V, we opt to form a portfolio that will buy ATM puts and

14 A one dollar change times a 0.01 change in moneyness for a one-month option, multiplied by the 48.47
coefficient on I, results in a 0.02% change in VIX.
15 For example, Jackwerth (2000), Aït-Sahalia, Wang, & Yared (2001), Coval & Shumway (2001), Bakshi &

Kapadia (2003), Bondarenko (2003), Bollen & Whaley (2004), and Liu, Pan, & Wang (2005) generally find that
the historical costs of puts, particularly OTM and ATM puts, are too expensive to be justified.

24
OTM calls, and sell ATM calls and OTM puts. This will allow the portfolio to benefit from

volatility shocks by having a put spread, but will have a relative low cost from selling a call

spread. This call spread not only funds the volatility protection but combined with the net

long equity positon can have a payoff structure similar to a covered call. This means that the

portfolio is susceptible to underperformance if there are big upward moves in the market.

Since one of the hurdles in replicating VIX is the difficulty in daily rebalancing costs

of the options, the replicating portfolio will enter into the put and call spreads investments

at the beginning of the month, using both the front maturity options only. The investment in

the options will only occur when the VIX index is below the plus one standard deviation level

since earlier results have shown the negative correlation and asymmetric response between

the VIX index and the S&P 500. The portfolio will hold the equivalent number of options

corresponding to 100 shares in the index, while accounting for the margin required by selling

options. As such, 20% of the notional value of the portfolio to invest in volatility will be used

equally to pay for the premium of the put spread minus the call spread and the margin

required for the short call spread. This somewhat penalizes the portfolio since the short call

positions are covered by the long equity investment. However, since the 80% long portfolio

has to be maintained, unless it is at 100% at higher levels of volatility, a call position that

finished in the money and is exercised will still require a selling of the underlying to cover

the expense, even on cash settlement. Following the exercise the portfolio must then be

rebalanced to achieve the 80%/20% ratio. To avoid this added complication, initially setting

aside cash for margin purposes reduces the added step from call option exercise. This fairly

simple structure, or synthetic VIX, has a correlation of 0.45 to the VIX index and has a similar

skewness that captures the asymmetric payoff to volatility

25
4.2. Performance of VIX Replication

FIGURE 3 shows the return to a portfolio that initially invests $1,000,000 in the S&P

500 only, the S&P 500 and VIX index, or the S&P 500 and the synthetic VIX portfolio, starting

January, 1996 and ending August, 2013.

[---Insert FIGURE 3---]

Since the synthetic VIX is an option structure, 2% of the portfolio’s funds are devoted

to a long position in the replicated VIX position when VIX is below the plus-standard

deviation threshold, otherwise, all funds are invested in the S&P 500. The performance of

the hedging strategy using the actual VIX position is shown for comparison purposes. The

return to the portfolio that incorporates the replicating VIX strategy outperforms the buy-

and-hold S&P 500 portfolio significantly. The annualized return to the hedged portfolio is

7.8% with an annual volatility of 12.5%. The return is 1.2% higher than the S&P 500 buy-

and-hold portfolio while being 3% less risky. On a dollar basis, this translates to almost an

$850,000 difference over the life of the investment. As table VI shows, the alpha from the five

factor model is 0.48 and significant at the 10% level, translating to an annualized alpha of

5.76%. This suggests that the replicating portfolio does a good job of capturing the hedging

benefits of holding the VIX index.

[---Insert TABLE VI---]

Using different levels of VIX as the threshold level has a minimal effect on the overall

return to the replicating portfolio unless the threshold level of VIX is below the minus-one-

standard deviation threshold. If a threshold VIX level of 12.5 is used, then the hedge does not

26
capture large declines in the S&P 500 and becomes moot as a hedge. The returns to the

portfolio that uses actual VIX holdings are significantly higher, which is unsurprising since

trading in the actual VIX portfolio does not account for transaction costs, bid-ask spread, or

portfolio turnover.

There is a specific downside to the synthetic VIX portfolio approach and ignoring VIX

levels above 36. Such a position cannot capture the extreme positive skewness in the VIX

index and is subject to crash risk. Hedging skewness in VIX, which corresponds to large

increases in the index and typically coincides with sharp declines in the S&P 500, is very

costly and thus not worth implementing consistently over a long period. For example, from

September through November of 2008, when the S&P 500 fell over 400 points and VIX

increased from a level of 20 to the high 80s, the synthetic strategy would have provided

protection given by the put spread only, while 80% of the portfolio would have suffered large

losses. This also would have occurred in March and September/October of 2001, July 2002,

May 2010, and August 2011 when VIX spiked and the S&P fell sharply. In total, the hedge

portfolio would not be able to cover significant market losses of greater than 5% in 26 out of

the 211 months in the sample. This doesn’t mean the portfolio underperformed, but it would

not be able to capture the full extent of the market losses.

It is not clear whether having a hedged portfolio that can result in positive return in

these extreme situations is worthwhile. The average loss in these 26 months for the S&P 500

is -8% while the synthetic VIX portfolio’s loss is -3%. That is a significant reduction in the

drawdown without the added expense that can mute normal returns. These tail risks, if

hedged consistently, would cost more than the total gains from the extreme event. This

leaves the portfolio manager with a difficult choice, namely, whether to buy expensive

27
insurance or expose the portfolio to significant jump risk. Since the replicating portfolio

captures the asymmetric relationship between volatility and returns, it can capture most of

the downside risk investors wish to hedge. The fact that the portfolio does not capture the

extreme negative skewness is a tradeoff to hedging most of the downside risk. However, a

potential alternative to hedging skewness is reverting to VIX calls.

Adjusting the portfolio to incorporate VIX calls as a hedge when VIX is above 28,

instead of the synthetic-VIX position, captures the extreme negative skewness without the

cost of S&P 500 puts. Using the calls at these levels is significantly preferable because the

cost of the calls does not dampen the potential return from volatility mean reversion. FIGURE

3 highlights this ability of the VIX calls to hedge the market decline in late 2008 as a result of

the positive skewness in the VIX index. This results in annualized return of 9.3% and a

volatility of 12.1%. As shown in Table VI, The alphas are significant for each regression

specification, and the annualized five factor model is 11.04% and is significant at the 5%

level. Additionally, the correlation between the combined synthetic-VIX and VIX call

portfolio and the VIX index is 0.58, and it is the use of the VIX calls to capture the positive

skewness in VIX that can really enhance returns. Thus, it appears that a portfolio that

combined the synthetic strategy with some VIX calls may provide the ideal hedging

combination to the long-equity portfolio.

5. CONCLUSION

Our results illustrate the feasibility and effectiveness of attempting to hold volatility

as an asset class in order to avoid market shortfalls by hedging downside risk. Since the

current asymmetric relationship between the VIX index and the S&P 500 generates the

28
strongest correlations when the market is falling, holding the VIX is a natural candidate for

hedging market risk. In fact, our results show that if VIX were investable, a portfolio

comprised of VIX and the S&P 500 would provide returns and risk levels that far outpace the

traditional buy-and-hold portfolio.

Of course, those initial results are hypothetical, and more so, not perfectly replicable

via investable VIX products because such assets price anticipated VIX mean reversion and

the mispricing cannot be arbitraged. The portfolio of holding VIX futures or the VXX ETN in

combination with the S&P 500 significantly underperforms. VIX calls, however, appear to be

a less expensive and more effective hedge of significant market downturns, outperforming a

more traditional protective strategy that utilizes S&P 500 puts. However, the expense of the

VIX calls is still a long-term hindrance on equity returns.

Understanding what is responsible for the changes in VIX is critical to assessing what

drives the asymmetric relationship between market prices and volatility. The largest

component responsible for positive VIX changes are front-month ATM puts. With this

understanding, a portfolio can be formed that holds a combination of long and short S&P 500

option contracts that best captures increases in VIX while keeping expenses low. This

synthetic VIX portfolio is quite liquid, and performs extremely well, capturing the increases

in VIX without proportionally penalizing the portfolio when the market increases. While this

portfolio does require the use of margin, it neutralizes the downside market risk investors

wish to remove while allowing for the upside gain. The aspect it cannot capture is the

extreme positive skewness in volatility. However, by holding VIX calls when appropriate,

investors may be further protected against significant shocks in the market in a much more

cost effective manner.

29
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31
TABLE I:
Correlations and Summary Statistics

TABLE I, below, demonstrates the correlation of monthly S&P 500 returns with the returns that would be realized from simultaneous investment in the
VIX index. Panel A presents results for the full sample. Panel B presents results for those months that experience an increase in the S&P 500 level while
Panel C presents results for months that experience a decrease in the S&P 500 level. Panel D shows the percentage of outcomes where the S&P 500 and
VIX had both positive, negative, and different signed returns in a given month.

Panel A: Full sample


N Mean Return Median Std Dev Skewness Kurtosis Correlation
S&P 500 287 0.70% 1.11% 4.27% -0.63 1.22
VIX Index 287 1.30% -1.35% 18.33% 1.17 2.64 -0.651

Panel B: Months with positive S&P 500 returns


N Mean Return Median Std Dev Skewness Kurtosis Correlation
S&P 500 181 3.22% 2.79% 2.41% 0.98 0.53
VIX Index 181 -6.52% -7.48% 12.40% 0.43 0.41 -0.283

Panel C: Months with negative S&P 500 returns


N Mean Return Median Std Dev Skewness Kurtosis Correlation
S&P 500 106 -3.61% -2.54% 3.38% -1.60 3.18
VIX Index 106 14.66% 10.14% 18.60% 1.17 2.11 -0.531

Panel D: Percentage of Monthly Outcomes

VIX + Return VIX - Return

S&P 500 + Return 17.07% 45.99%

S&P 500 – Return 28.92% 8.01%

32
TABLE II:
Relation Between VIX and S&P Returns

TABLE II, below, presents the results from estimating the regression using the entire sample from 1990 to
2009:
𝑟𝑉𝐼𝑋,𝑡 = 𝛼 + 𝛽𝑟𝑆&𝑃500,𝑡 + 𝛾𝑟𝑆&𝑃500,𝑡 2 + ε𝑡
where 𝑟𝑉𝐼𝑋,𝑡 is the return of the VIX index on day t, 𝑟𝑆&𝑃500,𝑡 is the return of the S&P 500 on day t, 𝛼 is a constant,
and ε𝑡 is the residual on day t. The column "Portfolio Weight of VIX to Hedge 5% S&P Drop" presents the
necessary proportions of VIX in a portfolio with the S&P 500 that yield a portfolio return of zero when the S&P
500 returns -5%, given the estimates from the regression. Robust test statistics are given in parentheses. *, **
and *** denote statistical significance at the 10%, 5% and 1% levels, respectively.

Panel A: VIX S&P Squared S&P Portfolio Weight of VIX to


Regressions Returns Returns Constant Hedge 5% S&P Drop
Full sample -2.70*** 7.25** 0.02* 0.225
(-11.80) (2.17) (1.86)
Months S&P 500
returns>0 -1.61 1.72 -0.02 -
(-1.33) (0.13) (-0.74)
Months S&P 500
returns<0 3.09** 1.18 0.03 0.209
(-2.53) (0.13) (1.17)

33
TABLE III:
Theoretical VIX Index and S&P 500 Portfolio Returns

TABLE III, below, provides return and abnormal return measures for portfolios that hold the S&P 500 and hedge using the VIX index. Panel A gives monthly results from
1996 to 2013 for threshold strategies which invest the prescribed dynamic hedge portfolio weight in the VIX and the remainder in the S&P 500 when VIX levels are below
the numerical level presented and entirely in the S&P 500 otherwise. Panel B presents analogous results for positions that invest from 2006-2013. Panel C shows results
for positions that invest from 2009-2013. Mean monthly returns are presented, as are the CAPM alpha and beta which result from the regression of monthly portfolio
returns on the value-weighted monthly market return, and the Carhart (1997) 4-factor alpha and market beta which result from the regression of monthly returns on the
three Fama and French (1993) factors (MKT, SMB, and HML) and Carhart’s (1997) momentum factor (UMD), which are obtained from Ken French’s website. The 5-Factor
model consists of the returns on an ATM or OTM straddle in addition to the factors in the Carhart model. Test statistics are given in parentheses. *, ** and *** denote
statistical significance at the 10%, 5% and 1% levels, respectively.

5-Factor 5-Factor
Panel A: Theoretical VIX CAPM CAPM 4-Factor 4-Factor 5-Factor 5-Factor
Mean (ATMS) MKT (OTMS) MKT
Strategy, 1996-2013 MKT Beta Alpha MKT Beta Alpha (ATMS) Alpha (OTMS) Alpha
Beta Beta
S&P500 Return 0.70***
(2.76)
No Threshold 0.83*** 0.15*** 0.55** 0.14** 0.61*** 0.15*** 1.39*** 0.21*** 1.72***
(3.80) (2.65) (2.39) (2.32) (2.69) (2.67) (5.03) (4.12) (5.56)
12.51 (-1sd) Threshold 0.74** 0.97*** 0.14 0.97*** 0.15 0.97*** 0.16 0.97*** 0.25
(2.38) (69.94) (1.53) (52.37) (1.55) (52.99) (1.33) (63.35) (1.48)
20.2 (Mean)Threshold 1.04*** 0.79*** 0.51** 0.78*** 0.54** 0.79*** 0.78** 0.82*** 1.09***
(3.33) (17.00) (2.49) (15.71) (2.53) (15.34) (2.52) (17.22) (2.94)
27.89 (+1sd)Threshold 1.09*** 0.41*** 0.71*** 0.39*** 0.78*** 0.40*** 1.51*** 0.47*** 1.98***
(4.02) (4.99) (2.78) (4.49) (2.92) (4.64) (4.14) (5.88) (5.16)
35.58 (+2sd)Threshold 0.95*** 0.30*** 0.62** 0.28*** 0.68*** 0.29*** 1.39*** 0.35*** 1.82***
(3.77) (3.62) (2.48) (3.13) (2.59) (3.22) (3.80) (4.25) (4.77)

34
Panel B: Theoretical VIX Strategy, CAPM MKT CAPM 4-Factor MKT 4-Factor 5-Factor MKT 5-Factor 5-Factor MKT 5-Factor
Mean
2006-2013 Beta Alpha Beta Alpha Beta Alpha Beta Alpha

S&P500 Return 0.40


(0.83)
No Threshold 0.87** 0.02 0.74* -0.09 0.81** -0.02 1.82*** 0.08 2.32***
(2.42) (0.17) (1.95) (-0.79) (2.26) (-0.21) (3.64) (0.93) (4.02)
12.51 (-1sd) Threshold 0.68 0.96*** 0.18 0.93*** 0.19 0.94*** 0.29 0.98*** 0.56
(1.41) (33.33) (0.98) (20.25) (1.03) (22.26) (1.07) (35.96) (1.35)
20.2 (Mean)Threshold 1.01** 0.72*** 0.61* 0.67*** 0.63* 0.71*** 1.05* 0.81*** 1.81**
(2.09) (8.17) (1.67) (6.47) (1.69) (7.13) (1.71) (8.59) (2.58)
27.89 (+1sd)Threshold 1.03** 0.38** 0.76 0.25 0.81* 0.31* 1.64** 0.45*** 2.53***
(2.24) (2.44) (1.65) (1.40) (1.85) (1.89) (2.20) (3.04) (3.29)
35.58 (+2sd)Threshold 0.96** 0.29* 0.73 0.13 0.79* 0.19 1.62** 0.31** 2.40***
(2.17) (1.75) (1.59) (0.72) (1.84) (1.11) (2.18) (2.00) (3.18)

Panel C: Theoretical VIX 5-Factor 5-Factor 5-Factor 5-Factor


Mean CAPM MKT Beta CAPM Alpha 4-Factor MKT Beta 4-Factor Alpha
Strategy, 2009-2013 MKT Beta Alpha MKT Beta Alpha
S&P 500 Return 1.47**
(2.55)
No Threshold 1.05** 0.08 0.86* -0.07 1.06** -0.09 2.01*** -0.03 2.47***
(2.63) (0.69) (1.82) (-0.59) (2.39) (-0.80) (3.08) (-0.32) (3.48)
12.51 (-1sd) Threshold

20.2 (Mean)Threshold 1.67*** 0.76*** 0.52 0.61*** 0.65 0.63*** 1.09 0.67*** 1.82*
(2.86) (8.07) (1.11) (4.99) (1.36) (5.16) (1.14) (6.44) (1.76)
27.89 (+1sd)Threshold 1.53*** 0.45*** 0.77 0.32* 0.92 0.32* 1.68* 0.37** 2.51**
(2.92) (3.19) (1.37) (1.89) (1.66) (1.94) (1.81) (2.60) (2.47)
35.58 (+2sd)Threshold 1.43*** 0.30* 0.86 0.11 1.02** 0.09 2.02** 0.16 2.75***
(2.91) (1.99) (1.53) (0.62) (2.04) (0.58) (2.61) (1.05) (3.32)

35
TABLE IV:
VIX Products and S&P 500 Portfolio Returns

TABLE IV, below, provides return and abnormal return measures for portfolios that hold the S&P 500 and hedge using the VIX futures, VIX calls, SPX Puts, and the VXX
ETN. Panel A gives monthly results from 1996 to 2013 for threshold strategies which invest the prescribed dynamic hedge portfolio weight in VIX futures and the remainder
in the S&P 500 when VIX levels are below the numerical level presented and entirely in the S&P 500 otherwise. Panel B presents analogous results for positions that invest
partially in VIX calls as hedging instruments, from 2006 to 2013.Panel C presents analogous results for positions that invest partially in S&P 500 puts as hedging
instruments. Panel D presents analogous results for positions that invest partially in the VXX ETN as a hedging instrument from 2009-2013. Mean monthly returns are
presented, as are the CAPM alpha and beta which result from the regression of monthly portfolio returns on the value-weighted monthly market return, and the Carhart
(1997) 4-factor alpha and market beta which result from the regression of monthly returns on the three Fama and French (1993) factors (MKT, SMB, and HML) and
Carhart’s (1997) momentum factor (UMD), which are obtained from Ken French’s website. The 5-Factor model consists of the returns on an ATM straddle in addition to
the factors in the Carhart model. Test statistics are given in parentheses. *, ** and *** denote statistical significance at the 10%, 5% and 1% levels, respectively.

Panel A: VIX Futures Strategy, 5-Factor 5-Factor 5-Factor 5-Factor


Mean CAPM MKT Beta CAPM Alpha 4-Factor MKT Beta 4-Factor Alpha
2006-2013 MKT Beta Alpha MKT Beta Alpha
No Threshold -0.59* 0.06 -0.73** 0.01 -0.68** 0.06 0.10 0.14 0.43
(-1.80) (0.60) (-2.13) (0.11) (1.99) (0.73) (0.23) (1.62) (0.86)
12.51 (-1sd) Threshold 0.41 0.97*** -0.09 0.97*** -0.08 0.96*** -0.09 0.99*** 0.16
(0.87) (55.51) (-0.80) (40.99) (-0.62) (40.39) (-0.47) (58.63) (0.87)
20.2 (Mean)Threshold -0.36 0.76*** -0.78** 0.71*** -0.78** 0.74*** -0.46 0.83*** 0.25
(-0.74) (12.06) (-2.36) (9.41) (-2.30) (9.85) (-1.02) (11.30) (0.55)
27.89 (+1sd)Threshold -0.71 0.49*** -1.02*** 0.41*** -0.98** 0.44*** -0.52 0.54*** 0.16
(-1.62) (4.45) (-2.66) (3.46) (-2.56) (3.82) (-0.97) (4.72) (0.29)
35.58 (+2sd)Threshold -0.72* 0.41*** -0.99** 0.30** -0.94** 0.33*** -0.47 0.42*** 0.12
(-1.70) (3.31) (-2.53) (2.44) (-2.49) (2.74) (-0.87) (3.52) (0.22)

Panel B: 2% VIX ATM Call 5-Factor 5-Factor 5-Factor 5-Factor


Mean CAPM MKT Beta CAPM Alpha 4-Factor MKT Beta 4-Factor Alpha
Strategy, 2006-2013 MKT Beta Alpha MKT Beta Alpha
No Threshold 0.72 0.01 0.60 -0.05 0.60 0.08 2.47 0.14 2.21
(0.78) (0.01) (0.55) (-0.07) (0.55) (0.14) (1.00) (0.24) (0.95)
12.51 (-1sd) Threshold 0.26 1.00*** -0.12*** 1.00*** -0.12*** 1.00*** -0.13** 1.01*** -0.06*
(0.53) (221.80) (-2.85) (168.64) (-2.83) (151.12) (-2.45) (172.55) (-1.68)
20.2 (Mean)Threshold 0.00 0.95*** -0.37*** 0.94*** -0.37*** 0.94*** -0.37** 0.96*** -0.17
(0.00) (48.36) (-3.65) (48.42) (-3.63) (48.42) (-2.56) (48.46) (-0.91)
27.89 (+1sd)Threshold -0.19 0.86*** -0.53*** 0.84*** -0.53*** 0.85*** -0.35 0.89*** -0.14
(-0.42) (21.15) (-3.97) (16.93) (-3.90) (19.53) (-1.59) (23.51) (-0.50)
35.58 (+2sd)Threshold -0.21 0.84*** -0.55*** 0.81*** -0.55*** 0.82*** -0.35 0.86*** -0.16
(-0.49) (19.30) (-4.03) (16.29) (-4.05) (18.69) (-1.55) (22.25) (-0.57)

36
Panel C: 2% SPX Put Strategy 5-Factor 5-Factor 5-Factor 5-Factor
Mean CAPM MKT Beta CAPM Alpha 4-Factor MKT Beta 4-Factor Alpha
1996-2013 MKT Beta Alpha MKT Beta Alpha
No Threshold -0.31 0.67*** -0.75*** 0.68*** -0.76*** 0.68*** -0.27*** 0.72*** -0.01
(-1.39) (22.63) (-10.37) (24.33) (-10.60) (47.37) (-3.68) (59.05) (-1.27)
12.51 (-1sd) Threshold 0.47 0.99*** -0.08*** 0.99*** -0.07*** 0.99*** -0.07** 1.00*** -0.02
(1.50) (342.61) (-2.82) (289.45) (-2.68) (286.79) (-2.10) (304.37) (-0.58)
20.2 (Mean)Threshold 0.05 0.92*** -0.48*** 0.91*** -0.47*** 0.92*** -0.32*** 0.93*** -0.14
(0.17) (48.67) (-6.65) (50.98) (-6.77) (50.43) (-2.75) (54.89) (-0.97)
27.89 (+1sd)Threshold -0.19 0.76*** -0.66*** 0.75*** -0.65*** 0.76*** -0.21 0.79*** 0.01
(-0.73) (18.97) (-7.02) (20.34) (-6.88) (23.98) (-1.50) (28.16) (0.08)
35.58 (+2sd)Threshold -0.27 0.72*** -0.73*** 0.72*** -0.74*** 0.73*** -0.28** 0.76*** -0.08
(-1.13) (18.70) (-8.42) (20.13) (-8.33) (23.86) (2.20) (28.55) (-0.60)

Panel D: VXX Strategy 5-Factor 5-Factor 5-Factor 5-Factor


Mean CAPM MKT Beta CAPM Alpha 4-Factor MKT Beta 4-Factor Alpha
2009-2013 MKT Beta Alpha MKT Beta Alpha
No Threshold -0.47 0.11 -0.64 0.01 -0.55 -0.02 0.36 0.04 0.96
(-1.27) (0.82) (-1.31) (0.05) (-1.18) (-0.16) (0.52) (0.40) (1.32)
12.51 (-1sd) Threshold N/A

20.2 (Mean)Threshold 0.26 0.79*** -0.79** 0.68*** -0.77** 0.69*** -0.48 0.72*** 0.37
(0.44) (10.92) (-2.41) (6.22) (-2.25) (6.35) (-0.66) (7.84) (0.53)
27.89 (+1sd)Threshold -0.29 0.47** -0.91* 0.36** -0.81 0.35* -0.08 0.40** 0.81
(-0.55) (3.16) (-1.68) (2.03) (-1.47) (2.00) (-0.09) (2.59) (0.80)
35.58 (+2sd)Threshold -0.32 0.33** -0.75 0.16 -0.62 0.14 0.31 0.20 1.13
(-0.65) (2.03) (-1.37) (0.90) (-1.23) (0.82) (0.40) (1.31) (1.34)

37
TABLE V:
VIX Factor Regression

TABLE V, below, shows the results from the following regressions:


𝑉𝐼𝑋𝑡
ln ( ) = 𝛼𝑡 + Δ𝑃𝜅,ϕ,τ,t + Δ𝐾𝑆𝜅,ϕ,τ,t + 𝐷𝑀𝜅,ϕ,τ,t + 𝐼𝜅,ϕ,τ,t + Δ𝑃𝜅,ϕ,τ,t ∗ 𝐶𝐷𝑡 + Δ𝐾𝑆𝜅,ϕ,τ,t ∗ 𝐶𝐷𝑡 + 𝜀𝑡
𝑉𝐼𝑋𝑡−1
and
𝑉𝐼𝑋𝑡
ln ( ) = 𝛼𝑡 + Δ𝑃𝜅,ϕ,τ,t + Δ𝐾𝑆𝜅,ϕ,τ,t + 𝐷𝑀𝜅,ϕ,τ,t + 𝐼𝜅,ϕ,τ,t + 𝜀𝑡
𝑉𝐼𝑋𝑡−1
Where Δ𝑃𝜅,ϕ,τ,t is the change in price of 𝜙(call/put) option with a strike of 𝐾 and maturity 𝜏 at time t. Δ𝐾𝑆
represents the change is moneyness of the option, where put moneyness is equal to S/K and call moneyness is
equal to K/S. Thus, more positive changes bring both definitions of moneyness closer to ATM. 𝐷𝑀 is the time
to maturity of the option, and 𝐼 is the interaction of all three variables. 𝐶𝐷 is a dummy variable equal to one if
the option is a call and zero if the option is a put. The first regression interacts the dummy variables with change
in price and moneyness variables to capture differences between call and put options. The second regression
examines the effect of price and moneyness changes of calls and puts separately on VIX changes. Each
specification clusters the standard errors by date to avoid overstating the t-statistics. Test statistics are given
in parentheses. *, ** and *** denote statistical significance at the 10%, 5% and 1% levels, respectively.

Puts Only Puts Only Calls Only Calls Only


VIX>20.8 VIX<20.8 VIX>20.8 VIX<20.8
VIX VIX >0 VIX <0 VIX VIX VIX VIX
ΔP 0.248*** 0.339*** 0.198*** 0.203*** 0.818*** 0.112*** 0.346***
(7.36) (4.91) (7.98) (6.67) (9.18) (3.81) (4.70)
ΔKS 331.8*** 210.6*** 172.5*** 301.1*** 448.5*** -364.4*** -636.3***
(32.68) (13.11) (16.07) (27.59) (21.61) (33.74) (21.62)
DM -1.031 -1.292 0.55 -0.922 -4.73** -0.197 -3.983**
(1.35) (1.25) (0.76) (0.91) (3.12) (0.17) (2.62)
ΔP*CD -0.140*** -0.262*** -0.043
(3.88) (2.80) (1.06)
ΔKS*CD -732.0*** -510.7*** -407.1***
(38.11) (17.27) (19.58)
I 48.47*** 15.45 19.69*** 38.08*** 456.8*** 44.17*** 413.8***
(4.76) -0.69 (4.80) (4.61) (4.42) (2.64) (3.38)
Constant 0.260*** 2.96*** -2.62*** 0.427*** 0.533*** 0.306** 0.381**
(2.85) (24.20) (31.39) (3.63) (3.94) (2.33) (2.37)
OBS 33681 15813 17718 9437 8177 9358 6682
R-squared 0.57 0.39 0.35 0.61 0.55 0.65 0.57

38
TABLE VI:
Synthetic VIX and S&P 500 Portfolio Returns

TABLE VI, below, provides return and abnormal return measures for portfolios that hold the S&P 500 and hedge using a synthetic VIX portfolios
constructed from a VIX factor regression. The table presents monthly results from 1996 to 2013 for a threshold strategy which invests the prescribed
dynamic hedge portfolio weight in synthetic VIX and the remainder in the S&P 500 when VIX levels are below +1sd threshold and entirely in the S&P
500 otherwise. Mean monthly returns are presented, as are the CAPM alpha and beta which result from the regression of monthly portfolio returns on
the value-weighted monthly market return, and the Carhart (1997) 4-factor alpha and market beta which result from the regression of monthly returns
on the three Fama and French (1993) factors (MKT, SMB, and HML) and Carhart’s (1997) momentum factor (UMD), which are obtained from Ken
French’s website. The 5-Factor model consists of the returns on an ATM straddle in addition to the factors in the Carhart model. Test statistics are
given in parentheses. *, ** and *** denote statistical significance at the 10%, 5% and 1% levels, respectively.

Panel : Synthetic VIX


Strategies, 1996- 5-Factor 5- 5-Factor 5-
2013 (+1sd Mean CAPM MKT Beta CAPM Alpha 4-Factor MKT Beta 4-Factor Alpha MKT Factor MKT Factor
Threshold) Beta Alpha Beta Alpha

Synthetic VIX 0.65*** 0.46*** 0.28 0.42*** 0.28 0.42*** 0.23 0.43*** 0.48*
(2.62) (6.85) (1.34) (6.27) (1.29) (6.28) (0.90) (6.31) (1.83)
Synthetic VIX (w/ VIX
0.78*** 0.29** 0.46* 0.24* 0.52* 0.24* 0.72* 0.27** 0.92**
calls)
(3.23) (2.49) (1.88) (1.88) (1.88) (1.95) (1.71) (2.23) (2.21)

39
FIGURE 1: Theoretical Portfolio incorporating VIX Index as a Hedge

FIGURE 1, below, tracks the performance of investment strategies incorporate the holding of the VIX index as
an asset. The results present the dollar returns for a portfolio that hold VIX unconditionally, when VIX is below
the historical plus one standard deviation level (VIX (1+SD)), and the buy-and-hold S&P 500 portfolio. The
starting value of the portfolio is $1,000,000.

$10,000,000
$9,000,000
$8,000,000
$7,000,000
$6,000,000
$5,000,000
$4,000,000
$3,000,000
$2,000,000
$1,000,000
$-

1-Apr-13
1-Apr-98

1-Apr-01

1-Apr-04
1-Jan-05

1-Apr-07

1-Apr-10
1-Jan-96

1-Jan-99

1-Jan-02

1-Jan-08

1-Jan-11
1-Oct-96

1-Oct-99

1-Oct-02

1-Oct-05

1-Oct-08

1-Oct-11
1-Jul-97

1-Jul-00

1-Jul-03

1-Jul-06

1-Jul-09

1-Jul-12
VIX No Threshold VIX (1+SD) S&P 500

40
FIGURE 2: VIX Based Products Portfolio Returns

FIGURE 2, below, demonstrates the dollar returns to an investment strategy which invests in the buy-and-hold
S&P 500, the S&P 500 and theoretical VIX (1+SD), the S&P 500 and VIX futures, the S&P 500 and VXX, the S&P
500 and VIX calls, and the S&P 500 and S&P 500 puts, The results are show starting in 2009 when the VXX first
traded. The starting value of the portfolio is $1,000,000.

$2,500,000

$2,000,000

$1,500,000

$1,000,000

$500,000

$-
1-Nov-09

1-May-10

1-Nov-10
1-Jan-09
1-Mar-09
1-May-09

1-Jan-10
1-Mar-10

1-Jan-11
1-Mar-11
1-May-11

1-Nov-11
1-Jan-12
1-Mar-12
1-May-12

1-Nov-12
1-Jan-13
1-Mar-13
1-May-13
1-Sep-09

1-Sep-10

1-Sep-11

1-Sep-12
1-Jul-09

1-Jul-10

1-Jul-11

1-Jul-12

1-Jul-13
VIX (1+SD) VXX VIX Futures VIX Calls S&P500 Puts SPX

41
FIGURE 3: Synthetic VIX Portfolio Returns

FIGURE 3, below, tracks the value of portfolios that consist of the buy-and-hold S&P 500, the S&P 500 and
theoretical VIX (1+SD), the S&P 500 and synthetic VIX, and the S&P 500 and synthetic VIX plus VIX calls, The
results are show for the 1996-2013 period. The starting value of the portfolio is $1,000,000.

$9,000,000

$8,000,000

$7,000,000

$6,000,000

$5,000,000

$4,000,000

$3,000,000

$2,000,000

$1,000,000

$-
1-Jan-96

1-May-97
1-Jan-98

1-May-99
1-Jan-00

1-May-01
1-Jan-02

1-May-03
1-Jan-04

1-May-05
1-Jan-06

1-May-07
1-Jan-08

1-May-09
1-Jan-10

1-May-11
1-Jan-12

1-May-13
1-Sep-96

1-Sep-98

1-Sep-00

1-Sep-02

1-Sep-04

1-Sep-06

1-Sep-08

1-Sep-10

1-Sep-12
VIX (1+SD) Synthetic SPX Synthetic+ VIX_Calls

42