February 3, 2009
The concept of volatility as an asset class is the latest result of the never-ending quest to create products for consumption by the investor community. But while volatility might serve a useful purpose as a measure of investor sentiment, it is only a true asset class for the marketing purposes of Wall Street’s financial engineers.
Examples of efforts to characterize volatility as an asset class include research from Credit Suisse and a recent white paper from Standard and Poor’s.
The concept of volatility as an asset class is most often associated with the VIX index. VIX was introduced in 1993 to measure volatility in the S&P 100 index. Its value was the implied volatility derived from the Black-Scholes option pricing formula, using the price of at-the-money listed options on the S&P 100. It became known as the “fear index” because it provided an objective measure of the volatility embedded in market pricing.
In 2003, the Chicago Board Options Exchange altered the VIX calculation methodology, replacing the Black-Scholes methodology with a different calculation, replacing the S&P 100 with the broader S&P 500, and using a broader set of options instead of just at-the-money options. Options and futures are now available against the VIX index and they have attracted significant amounts of investors’ capital over the last two years.
Given the relatively recent introduction of the VIX index and futures and options contracts traded against it, very limited data regarding its historical performance exists. Nonetheless, the S&P study cited above identifies several performance characteristics:
- The returns of the index have been generally negative when measured over various holding periods
- The value of the index has diminished over time, with the exception of the period of extreme volatility in the fall of 2008
- The index exhibits “term structure decay.” This is a typical characteristic of futures markets in contango — where more distant contracts trade at a premium to current contracts. Investors pay a premium in a trading strategy where current contracts are rolled into successive futures contracts, in order to maintain a constant maturity;
- The VIX and the S&P 500 are strongly negatively correlated; they move in opposite directions.
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