Is the Cboe Volatility Index® being manipulated? It’s a provocative question that was on the lips of some investors and market watchers this past spring after they noticed unusual activity in the VIX® in April. We wrote about the episode, observing that what looks like manipulation isn’t necessarily so. The VIX could experience intense fluctuation for other reasons. Nevertheless, the VIX’s historical settlement process left it open to manipulation, and the controversy stung.
But something good may yet come of it: On June 20 the Wall Street Journal reported that Cboe is taking steps to revamp the monthly auction that determines the settlement price for VIX options and futures. Some might argue that Cboe’s hand was forced, since its equity shares were down 16% over the first half of 2018, with many analysts indicating that concerns about the VIX franchise were a leading cause.
Spring has stung: a VIX timeline
Sources: Cboe, Wall Street Journal
What is the VIX?
The VIX, commonly referred to as the market “fear gauge,” attempts to measure the 30-day expected volatility of the S&P 500® Index. It does this by looking at the implied volatility of short-dated, out-of-the-money S&P 500® Index options. Historically the VIX rises when the S&P 500® falls (investor fear increases) and falls when it rises (investor fear decreases). Futures and options on the VIX are settled monthly using an auction process for S&P 500® options to determine the final index settlement price. Many investors look to the VIX index as a forward indicator of market uncertainty.
What’s changing with the VIX?
In general, all the changes fall under the header of increased liquidity during the auction. First, Cboe has transitioned all S&P 500® Index options to a more electronic-friendly platform. As amazing as it may seem to some, until recently a large portion of S&P 500® option trading was constrained to traditional open outcry pits—think of Dan Aykroyd and Eddie Murphy in Trading Places, and you get the picture. The other big change is that Cboe plans to enhance quote streaming for traders, providing them with more frequent updates during the settlement auction.
The hope is that both of these changes will encourage more traders to participate in the market during auctions. The potential for more liquidity during the auction will make it difficult for nefarious actors to manipulate prices if, in fact, manipulation was occurring in the past. (It should be noted that the May and June VIX settlements passed without incident.)
The bottom line
What does all this mean for investors? As noted in our previous blog post on the VIX, no one ever claimed the index was being rigged outside of a very narrow settlement window. If you didn’t hold VIX options or futures into settlement, you were likely not affected. Thus, the changes will have minimal direct impact on most investors.
The indirect impacts, though, could be profound. The steps taken by Cboe make it more likely that the VIX shakes off the “rigged” taint and that its associated futures and options survive in the long term. Given how important the VIX is as a market indicator and benchmark, we’d argue this is a positive outcome for investors.
Potential Parametric solution
We manage over $17 billion in investment strategies that seek to capture the volatility risk premium (VRP), a well-researched return premium evidenced by the discrepancy between the implied and realized volatility of equity index options, the very options used in the construction of the VIX. Parametric has developed a series of sophisticated VRP strategies in an effort to meet different investor objectives.
Tom Lee, CFA, Chief Investment Officer, Equities and Derivatives
Tom leads Parametric’s Research, Strategy, Portfolio Management, and Trading teams, coordinating resources, aligning priorities, and establishing processes for achieving clients' investment objectives. Tom has coauthored articles on topics ranging from liability-driven investing to the volatility risk premium. He is a voting member of all the firm's investment committees. Prior to joining Parametric in 1994 (originally as an employee of the Clifton Group, which was acquired by Parametric in 2012), Tom spent two years working for the Board of Governors of the Federal Reserve in Washington, DC. He earned a BS in economics and an MBA in finance from the University of Minnesota. A CFA charterholder, Tom is a member of the CFA Society of Minnesota.
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