VIX and Volatility Derivatives: A Survey of Relevant

Financial Instruments and Pricing Models

Srinjoy Ganguly
IIM Ahmedabad
p14srinjoyg@iimahd.ernet.in

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.
1 Introduction
Given the ever-ascendant quantum of volatility afflicting the global landscape, the ever-fluid trade-
off between risk and return has, not surprisingly, gradually acquired paramount importance as the
cynosure of the financial milieu. The Black Scholes Merton model [1] takes a severe beating in this
regard as its assumption of constant volatility is drastically antithetical to the observed empirical
results wherein the market prices of options imply varying volatility parameters. One could possibly
leverage upon the entire gamut of option price information to obtain a risk-neutral estimate of the
complete realized volatility distribution. This could further be utilized to exercise valuations in order
to develop replication strategies to frame derivatives that could be used to hedge one’s exposure to
volatility. All such volatility securities are contingent upon the realized variance/volatility of the
underlying asset, which quite simply translates to the variance/volatility of the underlying asset’s
return over the life of the volatility derivative. A variance swap [2] has clearly replaced the erstwhile
popular notion of delta hedging as the most preferred mechanism to hedge against volatility
exposure, as reported here:

Volatility is becoming an asset class in its own right. A range of structured

derivative products, particularly those known as variance swaps, are now the
preferred route for many hedge fund managers and proprietary traders to
make bets on market volatility. [Financial Times, 2006]

Based upon the fertile precept of locking in a pure exposure to volatility, three distinct groups of
trading drivers now proliferate the market, viz. possible direction of future volatility movements, the
difference between realized and implied volatility, and, short volatility positions that warrant covers.
Quite expectedly, the market for volatility derivatives (primarily, an OTC market [3]) has borne
witness to rapid growth over the past decade and currently trades at a notional level of $50 – 55
million, daily. Thus, the pricing of volatility products and implementing effective hedging strategies
using them provides a very germane avenue for extensive research.

At the other end of the spectrum, the vast pool of uncertainty that investors always find themselves
meted with has spurred the mushrooming of a set of volatility indices which aim to serve as
instruments used to gauge the sentiments of the investors regarding the risk-return trade-off
posited by the market. The very first index pertaining to this class is the Volatility Index (VIX),
introduced by the Chicago Board of Options Exchange (CBOE) in 1993 [4], based on S&P 100 index
options [5]. India did follow suit, albeit a substantial delay of 15 years, by virtue of the India VIX
introduced by the National Stock Exchange (NSE), which measures the implied volatility from near-
term at-the-money CNX Nifty index options in an identical manner. The India VIX serves as a holistic
measure of the implied stock market volatility as it contains within its ambit both downside and
upside volatility. Quite intuitively, the VIX level is positively correlated with the risk perception
associated with the stock market, i.e. a higher VIX implies a risky perception while a lower one
signifies optimism, within the limits of bounded investor rationality. In order to map the VIX levels
with respect to actual changes in the ecosystem, a considerable amount of research has been done
to assign an appropriate weightage to each event causing a shift in the flavour of the perceived
market outlook, with the arrival of new information (financial news or otherwise) and the impact of
trading, having emerged as the most statistically significant precursors. Consequently, over the

1
years, VIX has emerged as not only an important reference point for optimal risk management but
also a tool used to lock in profits via aggressive trading.

One of the critical contributions of modern financial economics relevant to the discussion is the
modern portfolio theory, whose major postulate is the phenomenon of risk aversion among
investors. The term “risk aversion”, which in itself is quite self-explanatory, refers to the real-life
situation wherein investors would expect additional rewards for every additional quantum of risk
which they undertake. Furthermore, given that every investor operates within the realm of bounded
rationality, one’s affinity towards a risky venture varies as per the manner in which it is presented,
i.e. an equivocal characterization of the probabilistic future pay-off associated with an investment
can quite simply alter investor perceptions quite drastically. This feature, in contagion with the law
of diminishing marginal utility [6], therefore yields a methodology based upon preference-weighted
likelihood estimates [7] for computing risk whereby the downside associated with any event is a
time-variant subjective phenomenon derived from a customer’s risk averseness. Thus, this logic can
perfectly explain a multitude of financial blitzkriegs such as a string of low returns spurring an
increased quantum of risk averseness among investors, ultimately leading to a market downturn and
vice versa. Among the various consequences of varying degrees of risk aversion, the pricing of assets
and other financial derivatives (for ex. options) contingent on them, has featured most prominently
in literature. The perceived volatility patterns which arise when pricing financial derivatives with
varying underlying strike prices are referred to as volatility smiles. For financial options in particular,
the volatility smile has acquired a skewed shape (instead of a symmetric one) post the 1987 Black
Swan market crash [8], thereby exposing drawbacks in the Black-Scholes-Merton option pricing
formula and engendering a lot of research regarding the mathematical modelling of such volatility
smiles.

By virtue of this report, I wish to decode the various qualitative and quantitative aspects pertaining
to volatility-based hedging tools & models in general, with a specific focus on the market for VIX-
based products in India. The remainder of the paper can be divided into the following sections:
Section 2 intends to present a literature review pertaining to the different building blocks
constituting the paper; Section 3 posits a brief quantitatively-inclined summary of the volatility-
based products whose use is in vogue with regard to the current market scenario; Section 4 aims to
apprise readers of the various qualitative and quantitative aspects related to VIX trading, with a
particular focus on the Indian VIX market; Section 5 takes a quantitative risk management-like
approach in professing the evolution of the most common mathematical models used for VIX
pricing; and, Section 6 finally concludes this report.

2 Related Work
The VIX, popularly regarded the investor’s “fear index” per se, possesses within its ambit the ability
to convey what emotions the public at large bears regarding the market’s performance. Thus, a low
VIX signifies investor optimism (no potential risk) while a high VIX points to investor wariness (lots of
risk potentially). While some attribute this volatility to the regular bursts of information pertaining to
stocks which arrive on a regular basis, others concede that trading in itself sparks such uncertainty.
In fact, research pursued by Fama [9] & French [10] also yields a similar result, i.e. volatility is much

2
higher during trading hours than otherwise. In addition to this, French & Roll [11] question the very
fundamental notions pertaining to the impact of the arrival of new information upon the market
volatility. Relevant findings derived from empirical research pertaining to the flow of information,
achieved by macroeconomic news & views, is posited in [12 - 13], while the impact of private
information in the same arena is explored in [14 - 15]. With the advent of behavioural economics,
the regular spells of topsy-turvy uncertainty has time and again been attributed to the bounded
rationality wielded by investors, and related issues have been explored significantly in [16 - 17]. In a
similar vein, investor sentiment particularly has been studied by virtue of a noisy trader model, as
discussed in [18].

Although a substantial amount of research thus far has been dedicated towards the prediction of the
volatility trends pertaining to critical macroeconomic variables, the amount of research dealing with
optimal investment strategies given concrete views of volatility trends is much more limited. Thus
volatility indices emerged towards the turn of the millennium to facilitate the trading of volatility.
Gastineau [19] and Brenner-Galai [20] are popularly considered as pioneers in mooting the idea of
volatility-based indices while Whaley [21] is credited for proposing the development of derivatives
based upon the aforementioned indices. A host of valuation models have been used for options
based on volatility, starting from binomial processes, proposed by Brenner [22], and continuous time
mean-reverting processes, originally posited by Grunbichler [23].In a slight departure from the
current context, hedging volatility via cliquet options, originally valued by Conze [24], has gained
widespread popularity since being introduced. In response to a growing demand for volatility-backed
contracts, OMLX (i.e. the London-based subsidiary of OM, the Swedish exchange) was the first to
launch futures trading on volatility as early as 1997. Likewise, Deutsche Terminborse (DTB) was the
first to initiate its own implied volatility index. However, the early response to these initiatives was
rather lukewarm as investors were comfortable with traditional volatility hedging strategies, as
proposed by the likes of Neuberger [25], Litzenberger [26], Dupire [27], among others. Dupire, in
particular, was instrumental in defining the concept of forward realized volatility, based on the
seminal HJM interest rate model [28]. One could really see a palpable rise in the volume of
derivatives being traded on volatility, with the introduction of VIX futures (2004) and VIX options
(2006). With precepts similar to the S & P, the DAX and the Euro STOXX 50 indices started the VDAX
and the VSTOXX, respectively, in order to facilitate volatility-backed trading.

In modelling VIX derivatives, the characterization of the underlying index as a martingale under a
chosen pricing numeraire is extremely popular. This schema has formed the basis for a host of
pricing techniques, as described in [29 - 31], with Zhang’s approach (based on an underlying Heston
diffusion process [32]) for pricing VIX futures being the most widely used one. Several practitioners
have also flirted with stochastic variance models positing time-variant parameters, for ex. Sepp’s
approach, as proposed in [31]. The other approach used extensively, popularly referred to as the
“market model approach”, entails the modelling of variance swaps directly. The most popular
techniques based on this approach are the ones proposed by Bergomi [33] and Cont [34]. Each of
the two approaches has their fair share of pros and cons. While the former scores several brownie
points owing to their relative simplicity, capturing market trends very accurately using such models
has proved to be quite difficult. On the contrary, the latter is majorly immaculate in capturing
market trends albeit at the cost of limited tractability. Apart from these approaches, several early
approaches to VIX option pricing entailed the use of different affine & non-affine variations of the
generalized autoregressive conditional heteroscedasticity (GARCH) model, wherein a review of the

3
evolution of this approach over the years has been presented in [35]. The ideal slope characteristic
of the implied volatilities emerging from a model, when applied to VIX options, is indeed a point of
immense dispute. Gatheral’s seminal work, proposed in [36], provides a wonderful vista to
understand the dependence of this slope upon the maturity of the concerned option. Heston’s
model for characterizing the underlying process is proved to be somewhat deficient in this regard as
the slope of the implied volatilities emerging from VIX options turns out to be downward sloping.
The 3/2 diffusion model, on the other hand, shows great efficacy in capturing this phenomenon
appositely thereby rendering it fit for robust VIX option pricing, as discussed in [37 - 39]. The model
is more parsimonious than its peers wherein it is able to perfectly track the joint dynamics of
equities and volatility derivatives. In order to abrogate the relative inefficiency of this model in
pricing VIX options with short-term maturities, jumps are incorporated in tandem with a standard
3/2 diffusion process, as posited by Baldeux & Badran [40].

3 Relevant volatility products

Table No. 1 Geometric Brownian motion variables

Symbol Meaning
Vt Variance of the underlying stock returns at time “t”
ρ Speed of mean reversion
α The long-run mean variance metric
σv Volatility of the variance process
Xt1 & Xt2 Two independent standard Brownian motions
r The risk-free rate of interest
η Instantaneous correlation between returns & volatility

Volatility and variance swaps are second generation volatility products which are essentially forward
contracts in which one party agrees to pay the other the amount by which the realized level of
volatility differs from a pre-determined fixed level (Kvar & Kvol, respectively), wherein the difference is
aptly scaled by the contract’s notional value (Ns). The payoffs for variance swaps (Pvar) and volatility
swaps (Pvol) are represented in Eq No (1) and Eq No (2), respectively, wherein V(0, n, T) [defined in Eq
No (3)] represents the variance of stock returns over the life of the contract, viz. [0, T] over “n”
discrete sampling dates at a given annualization factor (AF). Since the sample of stock prices usually
yield an average close to zero, the realized variance is invariably close to the sample variance. As
each time partition becomes infinitesimally small i.e. “n” becomes infinitely large, the posited
variance approaches continuous-time, as defined explicitly in Eq No (4).

Pvar  (V (0, n, T )  K var )  N s [1]

Pvol  ( V (0, n, T )  Kvol )  N s [2]

2
 AF  n1   Si 1  
V (0, n, T )   . ln [3]
 n  1  i 0   Si  

4
 Lt V (0, n, T )  V (0, T ) [4]
n

Assuming that the underlying asset, i.e. the stock price at time a given instant of time (St) adheres to
Heston’s stochastic volatility model under risk-neutral conditions, the relevant geometric Brownian
motion descriptors for stock price and volatility are stated in Eq No (5) and Eq No (6), respectively.
The latter is of special interest as it explicitly characterizes the instantaneous volatility as a quantity
which exhibits mean-reverting characteristics. The terms whose values the two characteristic
equations are contingent upon are defined in Table No (1).

dSt  (rSt ) dt  St Vt ( dX t1  1 - 2 dX t2 ) [5]

dVt  .(  Vt ) dt   v Vt dX t1 [6]

T
1
V (0, T )   Vt dt [7]
T0

*
Kvol  K var
*
[8]

The concept of instantaneous volatility (Vt) can be related to the notion of volatility over a specific
period of time (ref: Eq No (4)) as per the formal definition given in Eq No (7). If we wish to draw a
similar link between fair strikes for volatility and variance call options, then, as per Jensen’s
inequality, the relation posited in Eq No (8) may be deemed adequate. However, this is only an
approximate solution which has been improved upon in [41]. Having presented a generalist view
regarding volatility-backed quantitative hedging, in the sub-sections which ensue henceforth, I shall
present a succinct account of the imperative features pertaining to the volatility derivatives in
vogue.

3.1 Variance Swap

1   1 
 dSt   
T T
1
V (0, T )       .V .S 2 dt
2  t t
0 t
S  2 0
S t 

2 T

or,  V (0, T )  2V (0, T )     dSt [9]
0 t 
S

As mentioned earlier, a variance swap’s payoff is the difference between the realized variance of
stock returns over a specific time period, over a fixed amount which, unless stated, is assumed to be
zero. Thus, by virtue of Ito’s Lemma, one can easily derive the relation presented in Eq No (9). From
the aforementioned relation, the replicating portfolio for a variance swap in terms of a log contract
is quite intuitive and would essentially comprise of:

5
 S 
 1 log contract whose payoff is:  2 ln  T 
 S0 
2 
   shares
 St 
T
2
   S
0
 dSt  2 bonds (value of each bond = Unity)
t 

As can be inferred quite easily, the position would essentially comprise of a static position in a log
contract, coupled with a dynamic position in shares in order to delta hedge the log contract. A
sample variance swap plot is presented in Figure No (1).

Figure No. 1 Stochastic variance swap payoff VS realized variance (initial: <V> = 0) [source: [42]]

3.2 Volatility Swap (Basis: standard deviation of the stock returns)

Similar to variance swaps, volatility swaps are used to hedge against volatility with the only
difference being that the basis for framing contracts is now the standard deviation of the stock
returns in the given period of time. However, unlike the variance swap, the exact pricing of a swap
based on the standard deviation of stock returns is much more involved due to the inherent
characteristics of the geometric Brownian motion describing the variation of the metrics such a swap
is contingent upon. Not surprisingly, this is a very germane topic of research which has garnered
significant research attention, with the results obtained from several quarters of such quantitative
excursions being reported in [42]. In the industry, most of the valuations of such swaps are, in fact,
done on the fly, by virtue of numerical methods. However, given a fixed numeraire for evaluation
(say, EQ), one can set definite upper and lower bounds on the implied volatility (IV) and the swap
value (SV) at initiation, i.e. time = 0, as posited in Eq No (10). A sample stochastic volatility swap
payoff plot is presented in Figure No (2).

6
  2  Q  S 
 .E0 ST  S 0   IV0  SV0   2 E0Q  ln  T   [10]
 S  
 0    S0 

Figure No. 2 Stochastic volatility swap payoff VS realized variance (initial: <V> = 0) [source: [42]]

3.3 Cliquet/ratchet Options

Options provide a wonderful vista to effectively hedge against exposure to one or more of the key
volatility-backed Greeks, viz. Volga, Vanna & Vega, by virtue of an optimal combination of positions
in butterfly spreads, risk-reversal strategies and straddle (or, strangle) positions. In a similar vein,
cliquet options, also called ratchet options, are currently the craze in the world of equity derivatives
given that such contracts mitigate downside risk significantly while maintaining robust upside
potential simultaneously. It is common knowledge that the efficacy of the Vega Greek in indicating
an exotic option’s volatility sensitivity is quite limited due to frequent inflection points in the
option’s Gamma profile. In this regard, one of the biggest advantages of these fixed-premium
products is their relative insensitivity to the underlying volatility model used to characterize the
market dynamics. The product essentially comprises of a series of start options with the first one
active immediately, the second one becoming active after the first one expires, and so on, wherein
each option is struck at-the-money upon stepping into its active phase. In general, cliquet options
have gained widespread popularity owing to the fact that they essentially represent a more
affordable version of look-back options. Furthermore, the relative ease of replicating cliquet options
via semi-static hedging strategies has made an analysis of the properties of such options much more
convenient. Although cliquet options are available in a variety of maturity periods, the market for 5
year maturity cliquet options is most liquid. A simplistic mathematical description for such an
option’s pay-off at a fixed global strike price of “K” is presented in Eq No (11). An indicative payoff
diagram for a cliquet option with both an upper and a lower cap is presented in Figure No (3).

7
 
 
Pcliquet   sup (St  K )  [11]
 0t T 

Figure No. 3 Payoff of a cliquet option with cap (norm.) = 0.5 & floor (norm.) = -0.5 [source: [43]]

4 Understanding the VIX (Focus: Indian market for VIX products)

The Global Recession of 2007-08 brought about a number of paradigmatic changes in the ways
things are done in the financial world. The relevant business news channels too could not escape this
maelstrom of change given that reporting the VIX (Volatility Index), and analyses backed by the
same, became commonplace in the aftermath of the crisis. Popularly regarded as the CBOE’s “fear”
barometer, the VIX, like any other mainstream index (Ex. Dow Jones, NASDAQ, etc), is computed on
a daily basis with the only difference being that the basis for the computation of this index is the
market volatility rather than price of the underlying stock. Introduced in 2008, the India VIX is our
country’s answer to feed such requirements of volatility estimates by investors in shaping their
views, and is regulated under the aegis on the National Stock Exchange (NSE).

The India VIX has been observed to having adhered to an asymmetric relationship with respect to
stock market returns, i.e. more often than not, the NIFTY index level is negatively correlated with the
changes in the India VIX levels. This relationship however proves to be not as significant for higher
deciles upon the market adopting a downward turn, thereby making it an ideal metric to insure
one’s portfolio against “rainy days” per se. By virtue of this section, I wish to focus on an issue closer
home, i.e. the relevance of the India VIX given the current market scenario, and the performance,
thus far, of the products contingent upon this index. But first, I would like to build a suitable
background for the findings I wish to posit in the latter sub-sections by discussing some basics
related to volatility smiles & skews.

8
4.1 Volatility Smiles & Skews

As mentioned earlier, the plot of the implied volatility of an option versus its strike price is referred
to as its volatility smile, wherein the volatility surface thus obtained is a function of the option’s time
to maturity and can be used as a pricing tool. In fact, the asymmetry of a volatility smile is directly
linked to the extent to which the Black Scholes pricing (dependent upon the strike price and time to
maturity) of the corresponding option is out of sync with what the actual price of the option should
be. Quite intuitively, in accordance with the put-call parity law, the volatility smiles for a European
put and a European call option respectively, based on the same underlying asset with the same
strike price and time to maturity are identical. In this section, we shall take a look at the volatility
curves (spot curves at a fixed time instant) for options based on two underlying asset classes: foreign
currency and equities.

Foreign Currency Options

The typical volatility smile for a foreign currency option is exhibited in Figure No. 4 and the implied &
log-normal distribution for a foreign currency option is shown in Figure No. 5. Quite evidently,
figures (4) & (5) are very closely correlated, in accordance with empirical results, and correspond to
the typical characteristic of such options: high volatilities exhibited when they are deep in-the-
money [44] or deep out-of-the-money [45]. The peaks are a direct result of the increase in the
number of jumps and fluctuating volatility, both of which become less pronounced as the option
maturity increases, thereby causing the smile to become less pronounced.

Figure No. 4 Volatility smile for foreign currency options (Source: [46])

9
 Figure No. 5 Implied & lognormal return plots for foreign currency options (based on empirical data) (Source: [46])

Figure No. 6 Volatility smile (skew) for equity options (Source: [46])

Equity Options

The typical volatility smile (skew) for an equity option is exhibited in Figure No. 6 and the implied &
log-normal distribution for an equity option is shown in Figure No. 7. Quite evidently, figures (6) &
(7) are very closely correlated, in accordance with empirical results, and correspond to the typical
characteristic of such options: the volatility associated with a deep out-of-the-money put (deep in-
the-money call) is much greater than the volatility associated with a deep in-the-money put (deep
out-of-the-money call). This phenomenon, termed as “crashophobia” (based on the 1987 Black Swan
crash), could be explained by virtue of the principle of leverage, i.e. as a firm’s equity value
diminishes, its leverage increases due to which the risk also increases, causing the firm’s equity to
diminish correspondingly in value.

10
 Figure No. 7 Implied & lognormal return plots for equity options (based on empirical data) (Source: [46])

4.2 Computation of India VIX

An indicator of the annualized market volatility estimate pertaining to the next 30 days (near-term),
India VIX is computed based on the near-month and mid-month best bid and ask quotes of out-of-
the-money NSE options. The methodology used to compute India VIX is identical to that followed by
the CBOE, with suitable modifications incorporated to make it suitable for the CNX Nifty (refer,
Figure No. 8). The key features pertaining to India VIX computation are listed in Table No. 2. The
variation of the India VIX, firstly on a solitary basis, and secondly, with respect to the Nifty index can
be inferred from Table No (4) and Figure No (5) respectively. The asymmetric relationship between
the India VIX and the CNX Nifty, a phenomenon that becomes especially pronounced at extreme
points, can be inferred from Table No (5).

Table No. 2 Key features of India VIX computation

Feature Key characteristic

Time to expiry The time to expiry is measured in minutes (not days) to enhance accuracy.
Interest rate NSE MIBOR (30 days or 90 days) is used as the risk-free rate as per expiry.
Fwd Index Level Taken as the latest available price for the relevant Nifty future contract.
Bid-ask Quotes The best quotes for the relevant contract (cubic spline regression used).

The key formulae used to compute India VIX (and the factors which it is contingent upon) are stated
in Eq No [12-14] wherein, the σ thus obtained is scaled up by a factor of 100 to arrive at the India VIX
value (measured in %).

11
 2
2  K  1 F 
    2i * exp( R f T ) * Q( K i )   
2
 1 [12]
T i  K i  T  Ko 

K i 1  K i 1
K i  [13]
2

M current  M settle  M other

T [14]
M
(For extreme values, K i is defined as the difference of that extreme strike price and the next
highest/lowest value)

Table No. 3 India VIX calculation framework variables

Variable Meaning
T Time to maturity
Ki Strike price of the ith out-of-the-money option (Ki > F (call option), Ki > F (put option))
F The forward Index Level
Rf The risk-free rate
Q(Ki) Mid-point of the bid-ask spread for the option with strike price Ki
Ko First strike price which is lower/higher than the forward index level (put/call)
Mcurrent The number of minutes left in the current day (till midnight)
Msettle The number of minutes in the settlement day (from midnight till trade close)
Mother The number of minutes in all the days in-between (including those two days)
M The total number of minutes in a year

Figure No. 8 Variation of India VIX with respect to Nifty till December ’13 (Source: NSE)

12
 Table No. 4 Variation in the year-wise closing value of the India VIX (Source: NSE)

Closing values of the India VIX

Year Mean Maximum Minimum
2010 21.81 34.37 15.22
2011 23.84 37.19 16.73
2012 19.72 28.92 13.04
2013 18.89 32.49 13.1

Table No. 5: Extreme Nifty returns & India VIX changes: 5 biggest winners & losers from ’08 to ‘12
(Source: NSE)

Date Nifty Return (%) Change (India VIX)

06/09/2009 -6.022 -0.30
30/03/2009 -4.289 0.39
17/08/2009 -4.286 1.19
22/09/2011 -4.169 -7.4
17/06/2009 -3.644 11.01
13/03/2009 3.8156 -3.03
23/03/2009 4.6241 1.22
02/04/2009 4.8069 -13.14
04/05/2009 5.053 -1.5
18/05/2009 16.334 0

4.3 The VIX phenomenon in India: The story thus far

Since its introduction in 2008, the India VIX did stir several whirlwinds and engendered several
discussions held at major financial forums which aimed to focus on the index’s potential as an
instrument which could be used to efficiently gauge and mitigate the harmful impacts associated
with market volatility. In natural succession, similar to the CBOE’s move to enable VIX trading in
2004, the first series of India VIX-based futures (refer: Table No. 6) were launched in February 2014.
Riding on record VIX values owing to the upcoming General Elections, where a change of guard
seemed inevitable, the trading of these futures lost significant steam post-July 2014 owing to a very
bullish market and consequently, a substantial decay in the volatility linked with the Indian economy
in general. In fact, the average trading volumes went down by a staggering quantum from 6610
contracts (first 4 months) to only a meagre 143 contracts (February ‘15), locking in a net turnover of
only Rs. 17 crores from November ’14 to February ‘15.

Different factions have professed a plethora of theories regarding the decline in the trading of India
VIX-based futures since July ‘14. Apart from the tangible decline in market volatility, several
institutional investors and hedge funds have stated that given the significant complexity of the
product, they have found the contract size and the weekly settlement cycle to be the most critical
barriers which have prevented increased market participation. Furthermore, the rather high
minimum collateral limit (set at 20%) which the contract entails have further repulsed investors from
going gung-ho as far as this product goes. Thus, the prevalent low liquidity has, by virtue of a domino
effect, set considerable limitations regarding the efficient discovery of a price which has further

13
inhibited the trading of India VIX-based futures. There are several experts who adhere to a starkly
different school of thought regarding the current scenario though. Several feel that the stringent
conditions which the contract entails will screen out participants who seek instant gratification. In
fact, they unambiguously agree that despite the relatively limited participation of retail investors
and HNIs (who adopt other measures to curb volatility), the participation of long-term, genuine
investors will eventually pick up once the understanding of the product improves. Eventually, after
apposite price discovery given a substantial level of liquidity, the trading volumes will pick up and
will, in all probability, usher in the trading of VIX-based options in India.

Table No. 6 India VIX-based futures contract specifications (Source: NSE)

Feature Specifications
Symbol INDIAVIX
Tick Size Rs. 0.0025
Quotation Price India VIX * 100
Trading Hours 9:15 AM – 10:30 PM
Expiry Day Tuesday (every week)
Contract Cycle 3 weeks
Final Settlement India VIX closing value (cash)
Margin 20%

Given the precedents based upon which the India VIX was established, the index has immense
potential to eventually emerge as a cogent framework used for risk management practices specific
to India. However, the first in the class of derivatives based on the India VIX (i.e. India VIX futures)
has not succeeded thus far in living up to all the expectations that the market had assigned to it
given the immense demand NSE received for such contracts in the first four months upon its launch.
Thus, one needs to carefully analyze the various facets of the contract in its current form and draw
out the gaps in its value proposition chain and posit suitable amendments (if any) to its fabric so that
it becomes attractive to both retail investors as well as long-short alternate investment funds.
Achieving a significant quantum of liquidity for these contracts is absolutely imperative if one wishes
to usher in more derivatives which implement volatility-based trading, thereby bolstering the risk
management framework pertaining to India.

5 An overview of different volatility (VIX) pricing models

In this section, I wish to briefly describe a couple of generalized volatility pricing models, which could
more specifically be used to compute VIX option price levels given market stock returns. The need
for this section arises from the fact that although there are a host of factors that affect VIX option
prices, no model accounts for the entire gamut of factors VIX option prices are contingent upon. All
the major models, developed primarily by quants working in the industry, leverage some strategic
approximation or another to achieve a trade-off of accuracy against computational complexity. Thus,
which model is most efficient in VIX pricing is still really a question which is open to debate even
today. In order to appreciate this limitation better, an intonation of the list of factors affecting VIX

14
option prices is warranted. Although it is close to impossible to list down all the factors (both
qualitative & quantitative) that influence VIX option price levels, a dominant set of factors are:

 The reversion behaviour exhibited by the mean of the volatility distribution.

 Characteristics tantamount to stochastic volatility exhibited by the VIX, and the index it is based
upon.
 The absence of a robust cost of carry formulation.
 Anomalies in the settlement cycle associated with such contracts.

5.1 GARCH-based models

Since their introduction in 1986, the usage of a class of models collectively referred to as generalized
autoregressive conditional heteroscedasticity (GARCH) models has been in vogue, both among
academicians as well as practitioners. In addition to capturing volatility clustering and deviations
from the standard normal distribution along the tails, these models have been appositely bolstered
to account for a host of stylized facts such as the asymmetric effects of negative and positive returns
on volatility swings. Duan pioneered the concept of GARCH (p, q) model-based volatility pricing by
virtue of the seminal locally risk neutral valuation relationship (LRNVR) wherein he made some
assumptions pertaining to the utility function to be used in tandem with the GARCH (p, q) model
(refer: Eq No (15 - 17); It refers to the information accumulated by the system till time “t”). An
ameliorated version of this GARCH-based pricing framework, referred to as a generalized class of
stochastic autoregressive volatility models, is used for modern day VIX option pricing.

 S  1
ln  t   r   .ht  t [15]
 St 1  2

t | I t -1 ~ N (0, ht ) [16]

 
q p
ht  A0   Ai . t  i  c. ht  i  B .h
2
 i t i [17]
i 1 i 1

Under the stochastic autoregressive volatility assumption, the formula for computing VIX over a
specific period of time in accordance with a definite numeraire for computation (say, Q) is stated in
Eq No (18), where χ0 represents the time period (for ex. 30 days, or 22 trading days) over which the
VIX value is being computed.

t  0
 VIX t 
2
 1  ~ 
  h x dx 
   Et 
Q
[18]
 100     0  
 t 

A comparison of the VIX values obtained from this model with respect to the actual VIX values,
under absolutely identical conditions, issued by the CBOE reveals that the latter exceeds the former
on a consistent basis. Extensive research in this domain has revealed that the difference consistently
turns out to be equal to the risk premium associated with such a setting. As proposed in [47], this
essentially occurs due to the fact that under LRNVR evaluation, the numeraire Q does not accord an

15
adequate quantum of risk premium to the scenario while moving from physical to risk-neutral
valuation. Thus, even the most efficient of the GARCH family models (i.e. QGARCH models) also fail
to price VIX options with maximal efficacy owing to the aforementioned drawbacks intrinsic to the
basic fabric of such models.

5.2 Standard Black’s futures price-based model

As proposed by Whaley in [48], one may assume that the underlying volatility adheres to the
standard Geometric Brownian motion framework by virtue of which one can use Black’s model to
price options of futures. The biggest USP of this model is the fact that the estimation of additional
factors such as convenience yield, carry cost, etc becomes redundant as the basic input is the futures
price (F) observed in the market. Thus, the corresponding formulae for estimate relevant VIX option
values are stated in Eq No (19 – 21), where the various terms have the same meaning as the one in
Black’s original model.

VIX T  P(0,T )  ( F.N (d1 )  K.N (d2 )) [19]

 F    .T 
2
d1  ln      [20]
K  2 

d 2  d1   . T [21]

One of the pioneering models in this domain, Whaley’s proposition suffers primarily from one
ostentatious drawback: a sudden departure from the very notion of stochasticity in assuming a fixed
level of σ while carrying out valuations.

5.3 Mean-reverting geometric Brownian motion based pricing

Leveraging upon the seminal propositions of Cox, Ingersoll & Ross [49] in the characterization of
fixed income securities, and Heston’s formulation of volatility, a mean reversion-influenced
approach was framed to price volatility options. In estimating VIX, this model assumes that the
volatility index’s values will adhere to the characteristics of a mean-reverting square root process
under risk neutrality. The pricing formulae, thus derived, are represented in Eq No [22 - 26].

C (Vt , K , T )  e  rT (e  TVt  2 (K ;  4,  ))  m.(1  e  T ). 2 (K ;  2,  )  K . 2 (K ; ,  ) [22]

Here, the underlying VIX value varies, under a risk-neutral numeraire, as per:

dVt   .(m  Vt ).dt   Vt dX t [23]

Over here,  2 (...; ,  ) refers to a non-centralized chi-square distribution with degrees of freedom ν
and non-centrality λ. The remaining parameters are related to each other as per:

16
 4
 [24]
 .(1  e  T )
2

4 m
 [25]
2

   .e  T .Vt [26]

5.4 Model-free approaches to VIX pricing

Over the years, a steady stream of research output emerging from academia as well as industry has
focussed on arriving at closed-form expressions to price VIX accurately. In this regard, Carre’s
approach towards doing the same has gained widespread popularity since being introduced. The
precursors to their approach are replicating portfolios of the variance and volatility swaps, using
options on the S & P 500, that they posited in an earlier article. The associated volatility and variance
swap rates for their earlier model serve as inputs for this model. The complete formulation of this
model is presented in Eq No [27 - 31], wherein all the terms have the same meaning as pertaining to
Black’s original models. This Black-type model seems more cogent than Whaley’s original model as it
posits as definite formulation for the computation of forward rate volatility.

C ( Ft , K , T )  P(0, T ).( Ft .N (d1 )  K .N (d2 )) [27]

1  Ft & 2  Rt .e rT [28]

1
M t  2 ln 1    ln 2 [29]
2

t 2  ln 2  2 ln 1 [30]

 M  ln K 
d1   t   t & d 2  d1  t [31]
 t 

Over here, Rt , M t and  t refer to the variance swap rate, the time-conditional mean & the
standard deviation of the log-return pertaining to the volatility index, respectively.

5.5 3/2 diffusion model-based VIX pricing

The latest craze in the world of VIX option pricing has been the use of 3/2 diffusion models to price
volatility to a significant extent of accuracy. The model is especially suited for long-term index
options wherein it can perfectly capture the upward sloping volatility skew pertaining to equities.
However, the model is not as accurate for short-term index options, due to which several quants
proposed a fused model, i.e. 3/2 diffusion combined with jumps, in order to capture all the scenarios
with maximal efficacy. In this section, I shall speak briefly about one such model proposed by
Baldeux & Badran, wherein they have posted a 3/2 jump diffusion model that captures VIX option

17
prices for an incredibly broad vista of scenarios. The dynamics followed by the stock price and the
contingent volatility under such a framework are stated in Eq No (32) and Eq No (33), respectively.

 
dSt  St .(r   ' dt  Vt . .dX t1  1  2 .dX t2  (e  1).dNt ) [32]

dVt  kVt (  Vt ) dt   .(Vt 3 / 2 ) dX t1 [33]

In these equations, one can notice a close similarity with the model used to characterize variance
swaps earlier in this report, by Carre. The only difference is the (e  1).dN t factor which is used to
account for jumps in the model, wherein Nt represents a Poisson process and eω is used to
characterize relative jump size. The model for volatility is typical of a mean-reverting process with
the only difference being the exponential factor (3/2) which is unique to the (3/2) diffusion process,
whose speciality lies in the fact that it can capture the effect of several jump-like phenomena
without explicitly incorporating the same in the model. They have adopted a time-filtrated VIX
estimate, originally discussed in [50].

The models discussed in this section essentially intend to provide readers with a flavour of how VIX
pricing models have evolved over the days. Another feature that binds all the models discussed
herewith is that with the passage of time, models have gained accuracy at the expense of
computational tractability. Another keynote binding all these models is each model’s methodological
bias for the volatility process employed by the underlying cash instrument. Usually, all these models
work well for ITM options and options with longer maturity dates. This occurs because the volatility
surface professed by VIX derivatives differs from the one corresponding to SPX options. Thus, the
main contribution of the latter models (i.e. the ones proposed after Whaley’s seminal work) is the
pricing of shorter maturity options and options straying significantly away from DITM/ITM
conditions.

6 Conclusion
Based upon the precept of VIX being a widespread instrument used for risk management as well as
pure-play profit generation, this report intends to engage its readers in the different nuances
associated with various aspects pertaining to volatility in general, and the VIX, in particular. While
discussing the core aspects of the market for VIX derivatives, the report takes an India-centric view
wherein it intends to elicit a healthy discussion regarding the exact reasons for the concerned
market not really “taking off” in the Indian perspective, despite the initial high owing to the General
Elections. The latter half of the report intends to posit, albeit within its lofty limitations, a flavour of
the different mathematical models commonly used to price VIX options and hopes to impart a sense
of how the evolution of the most commonly used pricing model has taken place over the years. As a
future research direction, one could look at the joint calibration of VIX data coupled with the data
corresponding to the underlying stock index (S & P 500, or equivalently, Nifty) to explore the
performance of the various classes of pricing algorithms discussed in this report. Closer home, from
a policy perspective, one could work on precisely tracing the exact reasons why price discovery in
the Indian VIX derivatives market has not taken place thus far, so as to ensure that a robust VIX-
based risk management in the Indian perspective transcends steadily from rhetoric to reality.

18
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