The Diversification Benefits of Volatility Russell Rhoads CFA

The Diversification Benefits of Volatility Russell Rhoads, CFA Instructor – The Options Institute

CBOE Disclaimer Options involve risks and are not suitable for everyone. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of standardized Options. Copies may be obtained by contacting your broker or the The Chicago Board Options Exchange at 400 S. La. Salle St. , Chicago, IL 60605. In order to simplify the computations, commissions, fees, margin interest and taxes have not been included in the examples used in these materials. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results. CHICAGO BOARD OPTIONS EXCHANGE

Trading Volatility Summary – • Introduction to the VIX Index • Publicly Traded VIX Derivatives • Diversification Studies • Summary / Q&A CHICAGO BOARD OPTIONS EXCHANGE

VIX Index The VIX – CBOE Volatility Index. Measures S&P 500 implied volatility. Based on S&P 500 Option bid/ask quotes. Uses the nearby options with at least 8 days until expiration. Has been promoted as a ‘fear index’ by the business media. CHICAGO BOARD OPTIONS EXCHANGE

VIX Index A Brief History of the VIX – 1993 – VIX introduced in a paper. 2003 – VIX calculation changed. 2004 – futures contracts introduced. 2006 – options on VIX begin trading. 2008 – binary options on the VIX. 2009 – mini-VIX futures introduced. 2009 – VIX ETN’s introduced. CHICAGO BOARD OPTIONS EXCHANGE

VIX Futures • Value is $1000 x the level of the VIX Index. • Trade the next 7 months of expiration. • Expire on Wednesday 30 days before corresponding S&P 500 option expiration. • Have very unique characteristics relative to other financial futures. CHICAGO BOARD OPTIONS EXCHANGE

VIX Futures Mini VIX Futures • Value is $100 times the VIX Index. • Trade the next 3 months of expiration. • Expire on Wednesday 30 days before corresponding SPX option expiration. • Have very unique characteristics relative to other financial futures. CHICAGO BOARD OPTIONS EXCHANGE

VIX Futures Pricing – VIX Future August VIX – VXQ 9 @ 26. 90 = $26, 900. Minimum price move =. 05 or $50. +/- 1. 00 price change = +/- $1000. Mini-VIX August VIX – VMQ 9 @ 26. 90 = $2, 690. Minimum price move =. 05 or $5. +/- 1. 00 price change = +/- $100. CHICAGO BOARD OPTIONS EXCHANGE

VIX Futures Expiration Months – VIX Futures Next 7 Months Currently – Oct, Nov, Dec, Jan, Feb, Mar, Apr Mini-VIX Next 3 Months Currently – Oct, Nov, Dec CHICAGO BOARD OPTIONS EXCHANGE

VIX Futures Unique Features – Pricing is anticipatory, no ‘cost of carry’. Future price reflects market opinion of the future direction of the spot VIX Index. At times the VIX future price is higher than the index and at times it is lower. CHICAGO BOARD OPTIONS EXCHANGE

VIX Futures CHICAGO BOARD OPTIONS EXCHANGE

VIX Futures CHICAGO BOARD OPTIONS EXCHANGE

VIX Futures Expiration – Futures expire 30 days before the next month’s normal option expiration. Example – October VIX Futures Expire Wednesday October 21. Option Expiration is November 20. CHICAGO BOARD OPTIONS EXCHANGE

VIX Futures Settlement Pricing – VIX futures are AM settlement with a special calculation of the VIX Index taking place the morning after the end of trading for a futures contract. This is known as the Special Opening Quotation. CHICAGO BOARD OPTIONS EXCHANGE

VIX Futures Special Opening Quotation (SOQ) – This is a unique VIX index quote that involves only actual S&P 500 option trades. The regular VIX Index calculation uses the mid-point between bids and offers. The symbol for the SOQ is VRO. CHICAGO BOARD OPTIONS EXCHANGE

VIX Options Characteristics • European style • Unusual Pricing • Wednesday Settlement • Opening Price Quotation CHICAGO BOARD OPTIONS EXCHANGE

VIX Options European Style – European options are only allowed to be exercised on expiration. VIX options are cash settled at expiration. CHICAGO BOARD OPTIONS EXCHANGE

VIX Options Unusual Pricing – It is not uncommon for VIX options to appear to be cheap or expensive when using the VIX Index as the underlying. The proper underlying instrument should be the corresponding VIX future price. CHICAGO BOARD OPTIONS EXCHANGE

VIX Options Unusual Pricing – VIX Index @ 22. 00 VIX February 20. 00 Call @ 1. 25 VIX February Future @ 20. 50! CHICAGO BOARD OPTIONS EXCHANGE

VIX Options Unusual Pricing – VIX Index @ 27. 50 VIX March 30. 00 Put @ 1. 50 VIX March Future @ 29. 00! CHICAGO BOARD OPTIONS EXCHANGE

VIX Options Wednesday Settlement – Just like the VIX futures contracts, VIX options expire on the Wednesday 30 days before equity option expiration. CHICAGO BOARD OPTIONS EXCHANGE

VIX Options Opening Price Quotation – VIX Options are settled using the Special Opening Quotation on the morning following the last trading day for those options. This is identical to the settlement process for the VIX futures. CHICAGO BOARD OPTIONS EXCHANGE

VIX Options VIX Binary Options – • Introduced in 2008. • All or none payoff structure. • European Style. • Trade with the symbol BVZ. • Three near term months are listed. CHICAGO BOARD OPTIONS EXCHANGE

VIX Options Binary Options – Payoff Binary options pay the option holder $100 per contract if the option expires in the money. CHICAGO BOARD OPTIONS EXCHANGE

VIX Options Binary Options – Call – payoff if the settlement price is at or above the strike price. Put – payoff if the settlement price is below the strike price. CHICAGO BOARD OPTIONS EXCHANGE

VIX Options Binary Options – Available for download on the CBOE Website is a report on Binary Options. www. cboe. com/Institutional/reports. aspx CHICAGO BOARD OPTIONS EXCHANGE

VIX ETN’s VIX Exchange Traded Notes • What is an ETN? • Short Term Volatility - VXX • Intermediate Term Volatility - VXZ • Characteristics of these ETNs CHICAGO BOARD OPTIONS EXCHANGE

VIX ETNs What is an ETN? ETN stands for Exchange Traded Note, it is an unsecured, unsubordinated debt security. They are created to replicate returns on an index minus fees. The trading in ETN’s is very similar to that in ETF’s (Exchange Traded Funds). CHICAGO BOARD OPTIONS EXCHANGE

VIX ETNs i. Path S&P 500 VIX Short-Term Futures ETN (VXX) – Gives investors exposure to a daily rolling long position in the first and second month VIX futures contracts. CHICAGO BOARD OPTIONS EXCHANGE

VIX ETNs i. Path S&P 500 VIX Mid-Term Futures ETN (VXZ) – Gives investors exposure to a daily rolling long position in the fourth through seventh month VIX futures contracts. CHICAGO BOARD OPTIONS EXCHANGE

VIX ETNs Characteristics – • Exchange traded on the NYSE • Have a negative correlation to S&P 500 • index returns Backed by Barclays Bank CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification • It has been shown that in times of market • • weakness the benefits of diversification diminish The VIX index has a negative correlation with the performance of the S&P 500 There are several studies showing the benefits of exposure to a volatility asset providing diversification benefits to a portfolio CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification CBOE Study – • Focused on 2005 - 2008 asset class performance • Created a diversified portfolio using various exchange traded funds • Added weightings to VIX futures to the model portfolios to determine diversification benefit CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification 2008 Performance by Asset Class Emergin g Markets Internati onal Develop ed 54 % Real Estate 43 % U. S. Large Caps 37 % CHICAGO BOARD OPTIONS EXCHANGE Source: Credit Suisse Portfolio Strategy

VIX Diversification CBOE Study – Model Portfolio – • 35% Large Cap – SPY • 20% Small Cap – IWM • 30% Bonds • – 15% 7 -10 Year Treasury Fund – IEF – 15% 20+ Year Treasure Fund – TLT 15% Foreign – 10% MSCI EAFE Index Fund – EFA – 5% MSCI Emerging Markets Fund - EEM CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification CBOE Study – Portfolio Returns Year Diversified Portfolio SPY 2005 4. 73% 3. 01% 2006 11. 16% 13. 74% 2007 4. 51% 3. 24% 2008 -20. 99% -38. 28% 4 -Year -3. 87% -25. 34% CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification CBOE Study – Portfolio Volatility Year Diversified Portfolio SPY 2005 8. 41% 10. 33% 2006 9. 90% 10. 99% 2007 12. 10% 15. 86% 2008 23. 90% 41. 25% 4 Year 14. 90% 23. 29% CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification CBOE Study – VIX Enhanced Portfolios Diversified Portfolio VIX Enhanced Portfolio - 15% VIX Enhanced Portfolio - 30% Large Cap 35% SPY Small Cap 20% IWM Bonds 15% IEF 15% TLT 15% IEF 0% TLT 0% IEF 0% TLT Foreign 10% EFA 5% EEM Volatility 0% VIX Futures 15% VIX Futures 30% VIX Futures CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification CBOE Study – Enhanced Results Diversified Portfolio VIX Enhanced Portfolio - 15% VIX Enhanced Portfolio - 30% 2005 4. 73% 0. 70% -2. 57% 2006 11. 16% 8. 44% 5. 42% 2007 4. 51% 10. 70% 16. 84% 2008 -20. 99% -13. 08% -2. 92% 4 Year -3. 87% 5. 07% 16. 50% CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification CBOE Study – Enhanced Results 4 Year Avg. Return Std. Deviation Sharpe Ratio CHICAGO BOARD OPTIONS EXCHANGE Diversified VIX Enhanced Portfolio - 15% Portfolio - 30% -3. 87% 5. 07% 16. 50% -0. 98% 1. 24% 3. 89% 3. 03% 1. 93% 2. 14% -0. 41 -0. 31 0. 07

VIX Diversification CBOE Study – Summary • Study focused on using VIX futures exposure combined with traditional portfolios • Adding exposure to VIX futures in a portfolio of diversified assets would have resulted in better absolute and risk adjusted returns from 2005 – 2008 CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification University of Massachusetts Study – • Studied the 2008 market and the diversification benefits of VIX futures or options. • Compared a variety of portfolios and combined exposure to the VIX. • Results showed return and diversification benefits of including the VIX in a portfolio. CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification University of Massachusetts Study – • Looked at both VIX futures and options to provide exposure to volatility • Has a systematic approach to using these instruments to hedge a portfolio • Took a variety of portfolios and added VIX exposure to determine if there are diversification benefits CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification U Mass Study – Portfolio Construction • 99% Equity / 1% OTM VIX Calls • 97% Equity / 3% OTM VIX Calls • 59. 4% Equity / 39. 6% Bonds / 1% OTM VIX Calls • 58. 2% Equity / 38. 8% Bonds / 3% OTM VIX Calls • Measured Mar 2006 – Dec 2008 and Aug 2008 – Dec 2008 CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification U Mass Study – Mar 2006 – Dec 2008 Results Annualized Return Annualized Standard Deviation Annualized Sharpe Ratio 100% Equity -10. 30% 26. 85% -0. 47 99% Equity / 1% OTM VIX Calls -3. 29% 24. 86% -0. 23 97% Equity / 3% OTM VIX Calls 1. 24% 39. 99% -0. 03 60% Equity / 40% Bonds -3. 66% 15. 39% -0. 39 59. 4% Equity / 39. 6% Bonds / 1% OTM VIX Calls 2. 64% 18. 67% 0. 01 58. 2% Equity / 38. 8% Bonds / 3% OTM VIX Calls 6. 17% 38. 92% 0. 10 CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification U Mass Study – Aug 2008 – Dec 2008 Results Period Return Period Standard Deviation Period Sharpe Ratio 100% Equity -27. 87% 37. 73% -0. 74 99% Equity / 1% OTM VIX Calls 7. 95% 34. 96% 0. 22 97% Equity / 3% OTM VIX Calls 84. 41% 53. 38% 1. 58 60% Equity / 40% Bonds -15. 87% 21. 65% -0. 74 59. 4% Equity / 39. 6% Bonds / 1% OTM VIX Calls 22. 22% 26. 77% 0. 82 58. 2% Equity / 38. 8% Bonds / 3% OTM VIX Calls 103. 02% 51. 31% 2. 00 CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification U Mass Summary – • Focused on 2006 – 2008 and Fall of 2008 to test diversification benefit of exposure to volatility for a variety of portfolios • Most dramatic results came from using out of the money call options on the VIX as a small weighting of a traditional portfolio. CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification Summary – • Currently there are three methods to take a position based on the future direction of the VIX. • Studies show that exposure to these instruments results in improved risk / return characteristics for a variety of portfolios. CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification University of Massachusetts Paper – Full study available on the CBOE website. www. cboe. com/Institutional/reports. aspx CHICAGO BOARD OPTIONS EXCHANGE

VIX Diversification Summary – The CBOE Website has more information on these and other products. Questions / Comments? In Chicago and want to visit the CBOE floor? rhoads@cboe. com CHICAGO BOARD OPTIONS EXCHANGE