Before I dive into a series of posts about the VIX futures, I
think it is important to add some context in the form of several
observations about the relationship between the VIX and the
historical volatility ((HV)) of the S&P 500 index. In the
absence of any information about the future, it turns out that
historical volatility (a.k.a. realized volatility or statistical
volatility) can provide a reasonably accurate measure of future
volatility. In fact, it is more difficult than one might imagine to
incorporate information about the future to come up with a better
estimate of future volatility than what can be gleaned just by
extrapolating from recent realized volatility.
Looking at historical data, the VIX has an established history
of overestimating future realized volatility. In fact, in the 23
years of VIX historical data, there was only one year - 2008 - in
which realized volatility turned out to be higher than that which
was predicted by the VIX.
As the chart below shows, early traders made a habit of
dramatically overestimating future volatility. From 1990-1996, for
instance, the VIX overshot realized volatility by an average of
49%. Since 1997, the magnitude of that overshoot has dropped
dramatically, to about 24%, as investors apparently began to
realize that they had been overpaying for portfolio protection in
particular and for options in general.
(click to enlarge)
[source(s): CBOE, Yahoo]
That being said, 2012 has been an unusual instance in which the
VIX has overestimated 10-day historical volatility in the SPX by
47% - the biggest cushion since 1996. Not surprisingly, low
realized volatility tends to depress the VIX and the front end of
the VIX futures term structure in general. For that reason, the
unusually low average 10-day historical volatility of 12.25
experienced so far in 2012 can serve as a partial explanation for
the steepness of the VIX futures term structure (extreme contango)
yet given the history of even lower volatility numbers during
2004-2007, the low historical volatility for 2012 is at best a very
small portion of the full explanation. Two better potential
explanations for the steep VIX futures term structure are the
psychology of the 2008 financial crisis and its aftermath (i.e.,
disaster imprinting, availability bias, the recency effect, etc.)
and expectations of future higher volatility due to a geopolitical
and macroeconomic overhang that has generated a much higher level
of anxiety about future prospects than in more uneventful economic
times. Then, of course, there is the issue of the role of
mushrooming growth in VIX exchange-traded products as an influence
on the VIX futures term structure.
Before I address those issues in more detail, however, the next
installment in this series is a discussion of the evolution of the
VIX futures term structure.
What Does The Future Hold For DryShips?