October 18, 2012

VIX Term Structure’s Extreme Contango in 2012

At VIXandMore Bill Luby has an excellent series of posts on VIX describing how the markets affect VIX. Now he is analyzing the root causes of current extreme contango in VIX’s term structure.

VIX Term Structure October 17, 2012: source: VIXCentral

The movement of VIX, a derivative instrument, is often hard to predict.

2012 has been an unusual year with extreme global uncertainties still persisting in the market that is getting reflected in an extreme contango in VIX term structure (above).

For example, compare the current VIX Term Structure to that on October 17, 2008 right around the time of the market implosion.

VIX Term Structure October 17, 2008: source: VIXCentral

Bill Luby: 
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.

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.

VIX to Realized Volatility, source: VIXandMore

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.

Looking forward to more posts from Bill analyzing the VIX term structure contango in detail.

Tags: vix term structure, vix term structure contango, vix term structure october 2012, vix term structure october 2008, vix to realized volatility