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observer84
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why are vix futures in contango?

February 9th, 2014, 2:57 pm

Hi there,I was wondering why the vix futures curve is in contango most of the time. Searched and looked in several vix option pricing papers and empirical studies on vix futures and etp's on them but found virtually no explenation for this phenomenom. I understand that, from time to time, we observe backwardation / contango due to the mean-reversion property of volatility. So if we are in a crisis, the term-structure could be downward-sloping and vice-verca. However, that does not explain why we have contango in 80% of the time. My only explanation: Uncertainty regarding volatility is higher the longer you look into the future + we have risk averse investors..Would be nice to get some insights on this.bestobs
 
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Alan
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why are vix futures in contango?

February 9th, 2014, 3:47 pm

There is a pretty well-documented negative volatility risk premium. Why is it negative? I think of it like the insurance markets, where you are willing to 'pay up' above the actuarial expectation of the payoff in order to insure an asset. The result is that, with a neg. risk premium, your expected return when going longan insurance contract is negative. Similarly, people are willing to pay up to get long (say SPX) volatility exposure as a hedge/insurance against losses in the asset. That means your expected return when going long a VIX future is typically negative,which contributes to (is consistent with) the typical contango pattern. It's not a law of nature, though. People can change their risk attitudes. Also, even if you believe this story, it competes with the mean-reversion effect and I'm sure a bunch of other stuff to set the term structure at any point in time.
Last edited by Alan on February 8th, 2014, 11:00 pm, edited 1 time in total.
 
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observer84
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why are vix futures in contango?

February 9th, 2014, 7:34 pm

QuoteSimilarly, people are willing to pay up to get long (say SPX) volatility exposure as a hedge/insurance against losses in the asset. That means your expected return when going long a VIX future is typically negative, which contributes to (is consistent with) the typical contango patternThis is the part I do not completely understand. I get it that there is a variance risp premium which I have to pay by buying option contracts / going long variance swaps. But I don't see why there is an additional premium along the term structure of Vix futures. This future is an expecation of an expectation, isn't it?The contango effect seems to be present even with a mostly flat term structure of volatility.best,obs
 
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Alan
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why are vix futures in contango?

February 9th, 2014, 9:59 pm

Let's take some round numbers.Suppose the long-run mean SPX volatility is 18 (annualized vol points).Suppose the long-run mean VIX is 20Now suppose we are at a point in time where the spot VIX is equal to its long-run mean of 20.How should a VIX future (say maturing in a month) be priced?Suppose the (real-world measure) expected VIX value in a month is also 20. Then, if you are willing to pay up for long-vol exposure, you might pay 23 for the VIX future => contango.What motivates you to pay up for that is similar to the motive that causes you to pay upfor OTM SPX puts. But that second kind of thing contributes to causing the long-run VIX mean to be higher than the long-run SPX volatility. So, I agree that there are two somewhat different risk premiums being defined here -- but I think they are ultimately explained by the same motives. Unless I am missing something ---------------------------------------------------------------------------------------------------------------------------------------p.s. yes, the VIX future is an expectation of an expectation, both of which are market pricing measure expectations.So, for my example, if the future is at 23, the market pricing measure expectation of the spot VIX in a monthwill also be 23. This does not prevent the real-world expectation from being 20.
Last edited by Alan on February 8th, 2014, 11:00 pm, edited 1 time in total.
 
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sladner
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why are vix futures in contango?

February 10th, 2014, 4:38 pm

spx vol term structure is typically upward-sloping (1m IV < 12m IV, for example). think about your question in the context of how you would think about how to calculate a forward-starting interest rate if you had, say, a 1 month spot rate and a 12m spot rate. a vix future is akin to a contract on forward-starting implied variance. or, another related way would be to think about how you would hedge (or replicate) a vix future. think about the IV's of the instruments you would need to use to construct a (crude) hedge/replication for a near VIX future versus a long-dated VIX future
 
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observer84
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why are vix futures in contango?

February 10th, 2014, 8:38 pm

Thanks to both of you for your answers.QuoteSuppose the (real-world measure) expected VIX value in a month is also 20. Then, if you are willing to pay up for long-vol exposure, you might pay 23 for the VIX future => contango.Hmm, so let's say there are 2 futures contracts, short-and long-term. Both provide a hedge for volatility risk.But why is the long-maturity one quoted higher?Quote spx vol term structure is typically upward-sloping (1m IV < 12m IV, for example). think about your question in the context of how you would think about how to calculate a forward-starting interest rate if you had, say, a 1 month spot rate and a 12m spot rate. a vix future is akin to a contract on forward-starting implied variance. or, another related way would be to think about how you would hedge (or replicate) a vix future. think about the IV's of the instruments you would need to use to construct a (crude) hedge/replication for a near VIX future versus a long-dated VIX future Ok, if the term structure of volatility is upward-sloping it is obvious that long-term vix-futures are quoted higher. But as Alan points out, even for a flat TSOV there seems to be some kind of "term-structure premium" in the futures curve.Bestobs
Last edited by observer84 on February 9th, 2014, 11:00 pm, edited 1 time in total.
 
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EBal
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why are vix futures in contango?

February 10th, 2014, 10:43 pm

According to Keynes, contango is natural in this case. Hedgers are people who want to protect their long equity exposure, which means they go long VIX via its negative correlation to equities and speculators are short, hence "speculators will not go net short unless futures prices are expected to fall.".Also, I wonder whether significant difference in volatility of near term futures versus far out futures has anything to do with it.
 
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Alan
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why are vix futures in contango?

February 11th, 2014, 2:03 pm

Good point, EBal, re Keynes. It raises the question I touched on in this thread. Namely, in very stressed markets (like the Financial Crisis),we have nominal backwardation (the spot VIX is higher than the futures and their term structure is downwardsloping. But, to use your or acastaldo's language, I wonder if we still have Keynesian contango in thosesituations? (so the expected spot VIX at future time T is lower than the current VIX future maturing at T) Certainly with mean-reversion, the spot would be expected to fall. So it's potentially self-consistent.But with very pronounced nominal term structure inversion, it is somewhat counter-intuitive to me that the market expects thespot to fall that much. What is your take on that type of situation?
Last edited by Alan on February 10th, 2014, 11:00 pm, edited 1 time in total.
 
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gardener3
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why are vix futures in contango?

February 11th, 2014, 6:39 pm

QuoteOriginally posted by: AlanGood point, EBal, re Keynes. It raises the question I touched on in this thread. Namely, in very stressed markets (like the Financial Crisis),we have nominal backwardation (the spot VIX is higher than the futures and their term structure is downwardsloping. But, to use your or acastaldo's language, I wonder if we still have Keynesian contango in thosesituations? (so the expected spot VIX at future time T is lower than the current VIX future maturing at T) Certainly with mean-reversion, the spot would be expected to fall. So it's potentially self-consistent.But with very pronounced nominal term structure inversion, it is somewhat counter-intuitive to me that the market expects thespot to fall that much. What is your take on that type of situation?It should be easy to test. If VIX(t) - VIXfuture(t,T) is highly positive then VIX(T) - VIXfuture(t,T) should be positive, if I understood you correctly.
Last edited by gardener3 on February 10th, 2014, 11:00 pm, edited 1 time in total.
 
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daveangel
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why are vix futures in contango?

February 11th, 2014, 7:42 pm

I think the structure of the market is a big driver of this (this is quite self-evident but I thought I would start with that anyway). You have demand for "vega" i.e. demand for longer term options from institutional investors. The market makers supply this at a premium - and to hedge themselves they buy some "gamma" from retail customers at a "discount" to where they can trade it. Retail customers like to sell options because most otm options expire worthless don't they and are relatively price insensitive.
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tradelink
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why are vix futures in contango?

February 11th, 2014, 8:35 pm

I think dave's explanation and alan's first explanation are best.As alan alludes there are a lot of guaranteed return and other similiar institutional products that require insurance to construct the product.If you know somebody requires something, this is free money. so you pay spot or more to acquire them and trade them back to needier party (at a higher avg price so you can keep doing it). what keeps it from going up forever is essentially there are many ways to hedge. I don't know that much about the biggest counter parties in the vix but given it's one of the best known insurance products I'm guessing in a crunch it's like buying IBM for institutional managers (aka won't get you fired even if it's not the best).
 
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Alan
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why are vix futures in contango?

February 11th, 2014, 8:46 pm

QuoteOriginally posted by: gardener3QuoteOriginally posted by: AlanGood point, EBal, re Keynes. It raises the question I touched on in this thread. Namely, in very stressed markets (like the Financial Crisis),we have nominal backwardation (the spot VIX is higher than the futures and their term structure is downwardsloping. But, to use your or acastaldo's language, I wonder if we still have Keynesian contango in thosesituations? (so the expected spot VIX at future time T is lower than the current VIX future maturing at T) Certainly with mean-reversion, the spot would be expected to fall. So it's potentially self-consistent.But with very pronounced nominal term structure inversion, it is somewhat counter-intuitive to me that the market expects thespot to fall that much. What is your take on that type of situation?It should be easy to test. If VIX(t) - VIXfuture(t,T) is highly positive then VIX(T) - VIXfuture(t,T) should be positive, if I understood you correctly.Good point re testing. But if EBal's Keynesian natural contango is right (in all VIX markets, stressed or not), then I think the hypothesis here is that the realized value of VIX(T) - VIXfuture(t,T) is, on average, negative, (suggesting VIX futures are always expected to fall), regardless of the sign of VIX(t) - VIXfuture(t,T). At least that is my interpretation of what EBal is saying about (the proper application of) Keynes' theory to VIX. And you're right: that should be easy to test.
Last edited by Alan on February 10th, 2014, 11:00 pm, edited 1 time in total.
 
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EBal
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why are vix futures in contango?

February 11th, 2014, 10:25 pm

QuoteOriginally posted by: AlanQuoteOriginally posted by: gardener3QuoteOriginally posted by: AlanGood point, EBal, re Keynes. It raises the question I touched on in this thread. Namely, in very stressed markets (like the Financial Crisis),we have nominal backwardation (the spot VIX is higher than the futures and their term structure is downwardsloping. But, to use your or acastaldo's language, I wonder if we still have Keynesian contango in thosesituations? (so the expected spot VIX at future time T is lower than the current VIX future maturing at T) Certainly with mean-reversion, the spot would be expected to fall. So it's potentially self-consistent.But with very pronounced nominal term structure inversion, it is somewhat counter-intuitive to me that the market expects thespot to fall that much. What is your take on that type of situation?It should be easy to test. If VIX(t) - VIXfuture(t,T) is highly positive then VIX(T) - VIXfuture(t,T) should be positive, if I understood you correctly.Good point re testing. But if EBal's Keynesian natural contango is right (in all VIX markets, stressed or not), then I think the hypothesis here is that the realized value of VIX(T) - VIXfuture(t,T) is, on average, negative, (suggesting VIX futures are always expected to fall), regardless of the sign of VIX(t) - VIXfuture(t,T). At least that is my interpretation of what EBal is saying about (the proper application of) Keynes' theory to VIX. And you're right: that should be easy to test.I think some sort of test is right here.
 
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gardener3
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why are vix futures in contango?

February 12th, 2014, 1:31 am

QuoteOriginally posted by: AlanQuoteOriginally posted by: gardener3QuoteOriginally posted by: AlanGood point, EBal, re Keynes. It raises the question I touched on in this thread. Namely, in very stressed markets (like the Financial Crisis),we have nominal backwardation (the spot VIX is higher than the futures and their term structure is downwardsloping. But, to use your or acastaldo's language, I wonder if we still have Keynesian contango in thosesituations? (so the expected spot VIX at future time T is lower than the current VIX future maturing at T) Certainly with mean-reversion, the spot would be expected to fall. So it's potentially self-consistent.But with very pronounced nominal term structure inversion, it is somewhat counter-intuitive to me that the market expects thespot to fall that much. What is your take on that type of situation?It should be easy to test. If VIX(t) - VIXfuture(t,T) is highly positive then VIX(T) - VIXfuture(t,T) should be positive, if I understood you correctly.Good point re testing. But if EBal's Keynesian natural contango is right (in all VIX markets, stressed or not), then I think the hypothesis here is that the realized value of VIX(T) - VIXfuture(t,T) is, on average, negative, (suggesting VIX futures are always expected to fall), regardless of the sign of VIX(t) - VIXfuture(t,T). At least that is my interpretation of what EBal is saying about (the proper application of) Keynes' theory to VIX. And you're right: that should be easy to test.The average is very negative as ebal mentioned (although if you take the inverse and include the crisis, they are not as good as vxx would suggest). I was referring to the relationship you mentioned earlier that when the curve is inverted, the vix mean reversion would be less than expected by the market. In other words, would VIX(t) - VIXfuture(t,T) help predict VIX(T) - VIXfuture(t,T)
 
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Alan
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why are vix futures in contango?

February 12th, 2014, 2:19 am

Thanks, guys -- I am convinced.I spent the afternoon on this.Taking a long position in all available VIX futures each day from 2004, and computing the log returns to expiration, I findTS Obs Mean StdDevAny 17895 -0.11 0.36 Contango 14001 -0.13 0.35Backward 3876 -0.07 0.39Flat 18 0.04 0.38TS=Nominal Initial Term Structure, defined by the sign of the VIX spot - Future being consideredObs = number of observations Mean = Mean Log Return StdDev = Std Dev of Log Returns
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