MEMOIRE

En vue de lobtention du Diplme de Sup de Co Reims

REIMS MANAGEMENT SCHOOL

CYCLE MASTER
2010-2012

VOLATILITY AS AN ASSET CLASS: STUDY OF THE RISK

AND RETURN IMPACTS ON A PORTFOLIO

MEMOIRE ACADEMIQUE
PAR: Fernando PRIETO

JURY: Yves RAKOTONDRATSIMBA

MAY 2013

I would like to thank:

M. Bucchiccio Oliver, Head of Institutional Investor Sales at BNP Paribas, for the
inspiration

M. Lleo Sebastien, Finance Teacher/Researcher at RMS, for all the references

M. Sarter Stephan, Responsible for Master Thesis at RMS, for the patience and
assistance with paperwork.

And special greetings to M. Rakotondratsimba Yves, Teacher at ECE, for his tutoring.

Table of Contents
Asset classes ...................................................................................................................... 8
Volatility: Standard deviation, Variance and Covariance .................................................. 10
Correlation and diversification effect ............................................................................... 12
Volatility: Historical and Implied volatility ........................................................................ 14
Volatility Index: example of the VIX ................................................................................. 18
Volatility: from the Smile to the Skew .............................................................................. 21
Exposure to the VIX via swaps, futures, options ............................................................... 24
Risk adjusted return: Sharpe ratio and some others ......................................................... 29
Hypothesis 1: Volatility is a new asset class ...................................................................... 36
Hypothesis 2: Volatility improves risk-adjusted returns .................................................... 42
Hypothesis 3: Volatility protects from Black-Swans .......................................................... 49
Our conclusions ................................................................................................................ 55

Abbreviations and acronyms

c.

Circa

CAC40

Cotation Assiste Continue 40

CAGR

Compounded Average Growth Rate

CAPM

Capital Asset Pricing Model

CBOE

Chicago Board Options Exchange

DAX

Deutsche Borse Ag German Stock Index

e.g

For example

ETF

Exchange Traded Fund

ETN

Exchange Traded Note

i.e

That is

OTC

Over the counter

PF

Portfolio

Pp

Percentage point

S&P

Standard & Poors

SPX

S&P 500

SPXTR

S&P 500 Total Return

VIX

S&P 500 Volatility Index

Years (e.g. 10Y means ten years)

I Introduction
During my first internship at BNP CIB as equity and commodity derivatives sales
assistant, I was given the opportunity to discover a new category of products the bank wanted
to push: volatility products. A volatility product is defined as a security that provides
exposure to volatility alone without being affected by directional movements of the
underlying asset. This was a major surprise for me because as a Junior (and it was also the
case of not so junior people) volatility was a measure of risk.
Moreover, to simplify, some people spoke indifferently of volatility and variance. But
at that time the variance, for me, was not even a finance concept but a mathematical one. And
when I expressed my surprise to a sales I was working with, he answered: if you young
undergraduate, working for us on complex products in a daily basis and supposed to
understand, explain and sell these products are so lost, can you imagine the situation of the
clients? . That is why I decided to write my thesis on this new approach of a mathematical
and portfolio management concept. The goal of this study is to recreate the context and
constraints given to the banks that logically leaded to the creation of these products and
expansion of the market.
During the previous decades, liquidity has been the central concept of research in
finance. But the exhibit 1, a Google Ngram graphic (a Google Books tool analysing a
significant amount of books over time and giving as an output a graph showing how a phrase
have occurred in history) illustrates how, since the 90s, Volatility is the more commented
concept. We will see later that this date is in line with Variance Swaps creation!
Exhibit 1: Google Ngram graph for Liquidity and Volatility between 1930 and 2008

If some institutional investors and quants have started to work on this kind of project
in the 2000s, the intense development and growth of the volatility product market boomed
after the recent financial crisis and especially the collapse of Lehman Brothers in September
2008. Most of the asset classes declined sharply - a decline rarely explainable by the
fundamental methods of asset valuation. For example, in 2009, G. Subleys article
1

demonstrated that a 3000pts CAC40, the average level of 2009 (note that it reached its

lowest close level in March 2nd 2009, 2534.45pts), means that half of the underlying
companies are valued to a Price to Book-Value ratio of less than 1. He also demonstrates that
the multiples low levels are the result of an increasing uncertainty environment. In parallel of
that phenomenon, the correlation levels of the different asset classes increased dramatically.
In average from 1983 to 2007, the Equity and Commodities (considering the S&P500 and the
S&P GSCI) correlation level was 0,57: it increased to 0,91 during the 08-09 crisis.
What was the impact on for the portfolio managers? The Modern portfolio theory is
based on Markowitz approach of risk: it is measured by the standard deviation (or the
variance, its square). Then Markowitz derived the general formula to measure the standard
deviation of the whole portfolio of risky assets. Thanks to this formula he clarified the
relationship between the risk, the return, and the different assets correlation. Thus he was able
to demonstrate the impact of the correlation levels on the risk diversification: the global risk
level of a portfolio is less than the risk of carrying each asset independently if the correlation
coefficients are less than 1.
The challenge for the portfolio managers is to find an efficient way to diversify the
risk of their portfolios and optimize the return for each unit of risk. For that reason the asset
managers use different asset classes as they are exposed to different economical phenomenon
(e.g. when equities drop, the investors are supposed to sell it and invest in bonds and then
bonds will be negatively correlated to the equities). So what happen when the correlation
levels of the asset classes converge to 1? The level of undiversified risk carried by a portfolio
composed of these assets increases.

1 Analysed in

(Surbled, 2009)
6

Our idea here is to consider the volatility as an asset class. By volatility we mean the
implied volatility, the level implied by the market as it is derived from the mark-to-market of
the options (calls and puts). To be more precise, it is the volatility level matching the Black
and Scholes formula and the prices of the options on the market (in other words the implied
volatility is the future volatility level estimated by the market). Structurally it is uncorrelated
to the other asset classes (especially on bear markets). In 2008 after Lehman collapse, the
implied volatility levels reached records high levels across all the markets (for example the
VIX has reached its highest level 80,86 2 months after the crash of Lehman) when, as
mentioned before, the other assets where declining.
So the first hypothesis is about the volatility, in other terms the products allowing an
exposure to the volatility of assets, can we consider this set of securities as a new asset class?
To test this hypothesis, we will design a framework to define what is an asset class. Then we
will study the different solutions offered by investment banks to buy volatility or variance
with different wrappers (like swaps, options or shares in funds Voledge-like) and see if they
meet the definition of an asset class.
Then it will be interesting to study the impact of diversifying a portfolio of risky assets
with these securities. While volatility has a given return and risk profile in a given market, the
question then is to know how the portfolio will react to it in different situations and over time.
Do these assets allow a statically significant improvement of the risk to return profile of our
portfolio? The second hypothesis will be then is that the integration of volatility to a portfolio
of risky assets does improve the risk to return profile.
Finally, my third hypothesis will derive from the precedent: as the implied volatility
takes advantage of the market uncertainty, then we will test the efficiency of these products to
hedge a portfolio against what Nassim N. Taleb so-called a Black Swan - those huge, not
anticipatable, and highly improbable market movements. For example, during the last
financial crisis, the incredible surge in volatilities of most markets and especially the
observation of a rare phenomenon - the recorrelation of the asset classes in a bearish market caused a "Black Swan" out of the scope of usual Risk Management Scenarios. We will try to
test the efficiency of these solutions in extreme scenarios like these.

II State of the Art

Volatility products are highly technical; approximations and abuses of language are
very common in the industry about it. Thus we have decided to start with a global overview of
the required concepts. Moreover as the final goal of this paper is to help novice people to be
comfortable with volatility products, it appears relevant to start with the basics. As a
consequence, for that part of the study, I will particularly insist on the terminology and
definition of the concepts the lector could need to understand the analysis realised in the
second part of this research paper.

Asset classes
Asset classes are an asset allocation concept. The more frequent definition is: an
asset class is a set of assets that bear some fundamental economic similarities to each other,
and that have characteristics that make them distinct from other assets that are not part of that
class 2. The generally accepted traditional asset classes are: equities, bonds and cash. With
time, it is now widely recognised that there is some alternative asset classes: hard
commodities, soft commodities, real estate, and credits...
The idea of considering different asset classes is useful to diversify our exposure to
different economic factors or phases of a cycle. As this is out of the scope of this study we
invite the readers interested by the subject to consult the paper of Pim Van Vliet and David
Blitz Dynamic Strategic Asset Allocation: Risk and Return Across Economic Regimes to
know more about the asset allocation driven by the economic cycles. Our interest for that
theory here is limited to the proof it makes of the usefulness of the concept.
In this study we will use the following framework to define what an asset class is:

Does this asset class make sense as an economic factor? To answer that question
we can try to determine if the securities composing it have a homogeneous return
in a given economical context but it is also necessary to question the philosophy

2 Definition in (Greer,

1997)
8

of the product. In other words, it leads to answer a simple question: do these

securities give an exposure to the same economic factor?

Are the securities tradable? This criterion is in line with my intension of writing a
guide useful for the portfolio managers (and consequently close to the reality of the
market). This tradability criteria involve different questions:

The question of the general agreement on the measure of the return. We

will see that if it is easy to agree on the concept of the return, the way to
measure it is quiet different from a party to another

The existence of the securities and the market access. Neuberger and
Hodges (Neuberger & Hodges, 1989) published the variance swap
replication portfolio method (with a portfolio of options) in 1990 and the
first var-swap was traded in 1993. At that time the var-swaps was a very
small market with very restricted market access for years. It proves you
need to test the availability of the securities to define them as an asset class

More in depth the question of the securities liquidity still pending. If the
liquidity of an asset class condition, it is clearly a parameter and by
consequence need to be defined

Do these securities have a homogeneous risk/return profile? If this question is

close to the previous one, we will focus here more on the payoff structure than on
the timing or on the economic (or financial) background resulting in this return
for the security

My researches on how to define an asset class in the academic literature was not much
successful and it appears that for now the asset classes are more the result some arguments of
authority or empirical evidences than on a precise framework resulting in a classification. If
the framework allowing an asset class classification is not in the core of this study, I decided
to draft one and to use it in order to test my first hypothesis: can we consider volatility as a
new asset class?

Volatility: Standard deviation, Variance and Covariance

In 1954, Harry Markowitz wrote the efficient portfolio theory and in 1990 he received
the Sveriges Risksbank Prize in Economics Sciences in memory of Alfred Nobel for it. In his
theory, Markowitz defines the returns of an asset as a random variable. Consequently the
expected return is the average return and the risk is defined as the variance of returns or the
standard deviation (the square root of the variance) of the random variable.
Since then, the economists have highlighted the limits of this measure of risk of which
the more important is considering both up and down side equally risky, an irrelevant
hypothesis in most investment positions. Imagine a pharmaco stock with a given volatility.
The CEO of the company announce a vaccine against AIDS, the stock knows unusual positive
jumps in the stock exchange in prediction of the future positive expectations for the company.
As a consequence, the volatility (supposed to measure the risk) will rise. Does it make sense?
The market is only pricing the value of the future earnings! Another limit of the measure is
the high sensitivity to extreme figures (as we square the distances to the mean, the impact of
the extreme values is not linear).
But how is the volatility measured? The standard deviation is a 19th century
mathematical concept; it measures the variation (or dispersion) to the mean of a random
variable. The symbol used in mathematics is

and the standard deviation formula (1) is:

2
(1) X = E "( X E [ X ]) $
#
%

Where X is a random variable representing the returns of the asset

Then, the variance formula (2) is:
2
(2) V [ X ] = 2X = E "( X E [ X ]) $
#
%

In other words, the variance is the average of the squared distances to the mean and
the standard deviation is the square root of it. The advantage of the standard deviation is that
it has the same dimension than the mean.

10

Now it is necessary to define the variance of a portfolio. When Markowitz defined the
standard deviation as a measure of risk, then he derived the general formula for the variance
of a portfolio of risky assets (3):
(3) 2P = w i2 i2 + wi w j i j i, j
i

ji

Where wi and w j are the respective weights of the assets i and j in the portfolio P

Where i2 the variance of the asset i

Where i is the standard deviation of the asset i

Where i, j the correlation coefficient between the asset i and j

As this formula shows the dispersion is neutral to the mean. The sign of the distances to
the mean are completely neutral as they are squared. Again, this limit of the standard
deviation is important to note, as we will see later, this is not the case with tradable volatility
(cf the concept Volatility: from the Smile to the Skew).
If the variance is used to measure the variations of a variable with respect to itself, the
covariance will allow studying the simultaneous variation of variables from their respective
means. It can be noted indistinctly cov(X,Y) or X,Y . The covariance formula (4) is as
following:
(4) Cov(X,Y ) = E "#(X E [ X ])(Y E [Y ])$%

From this presentation of the covariance formula we can easily deduce a simple result:

cov(X,X) = 2X . Please note this second presentation of the equation:

(5) Cov(X,Y ) =

1
(Xi E [ X ])(Yi E [Y ])
N

Where

Xi is the value of the asset X at time i

Where

Yi is the value of the asset Y at time i

The lower the obtained result is, the more the series are independent and a move from one
will not impact the second. Conversely the higher it is, the more the series are linked. Two
independent variables have a zero-covariance.

11

Correlation and diversification effect

From the previous formula of the portfolio variance (3) we can understand the origin
of the diversification effect and the role of the correlation between the assets (and by
extension of the asset classes in it) in the volatility of a portfolio. Lets analyse it: as mentioned
before, the general formula of a portfolios variance is:
(3) 2P = w i2 i2 + wi w j i j i, j
i

ji

But what does the correlation coefficient i, j represent? The formula of it is:
(6) i, j =

cov(X,Y )
X Y

The formula (6) is easy enough to understand, the essential point is to understand the
relation between the correlation coefficient and the covariance for a given level of volatility of
the assets. Finally we can deduct the consequences on (2), and the relationship between assets
impact the volatility of the portfolio:

The more correlation we have between assets, the bigger the second term is. The
consequence is obviously a reduced impact on the non-systematic risk. At the
opposite, when we have low or negative correlation between the assets, then the
second term will be small or negative and we will reduce quicker the nonsystematic risk

The more assets we have, the smaller is the second term as the weights will be
reduced and the correlations range from -1 to 1 increase the effect. This lead us to
the exhibit 2 resuming the relation between the number of securities and the
portfolio variance

Portfolio variance (risk)

Exhibit 2: Portfolio volatility and Risk diversification

Non-Systematic risk

Systematic risk
12
Number of securities

Now that the concept of correlation between assets and asset classes is clear, it is
interesting to have a look on the real situation of the markets on the previous years. How
assets are correlated? In the exhibits 3 and 3bis, we will present US and HK Equity as
different asset classes because if both are equity, they give an exposure to very different
economic factors (cf. the presentation of the Asset Classes concept).
Exhibit 3: Performance evolution between different assets since 2000
During the recent crisis,
traditionally de-correlated asset
classes moved in the same
direction, hence reducing
diversification benefits

300

250

High diversification during

quiet times (relatively low
volatility regimes), when it is
less needed

Performance (%)

200

150

100

50

0
Jan-00 Aug-00 Mar-01 Oct-01 May-02 Dec-02 Jul-03 Feb-04 Sep-04 Apr-05 Nov-05 Jun-06 Jan-07 Aug-07 Mar-08 Oct-08 May-09 Dec-09 Jul-10

US Equities
European Equities
Hong Kong Equities
US Real Estate
US Bonds
Commodities
Diversified

Exhibit 3bis: Zoom on the increasing correlation of assets since 2005

1
0.8
0.6
0.4
0.2
0
-0.2
-0.4
European Equities
Hong Kong Equities
US Real Estate
Credit
Commodities

-0.6
-0.8
-1
2005

2006

2007

2008

nd

2009

2010

Source: BNP CIB - Bloomberg, Data from 22 March 2005 to 25th August 2010.
These two exhibits perfectly illustrate the recent constraints on the portfolio managers:
as we can see, the diversification of assets during the normal periods and the recorrelation
of the assets when they really need diversification: during the crisis periods. In this context, a
structurally negatively correlated asset, like the volatility, should be appealing for the asset
managers: here started the adventure of the volatility products

13

Volatility: Historical and Implied volatility

The historical volatility, also called realized volatility, is calculated as the variance of
the assets return time series. As it is easy to calculate and based on the hypothesis that assets
return follow a normal distribution, in the past years portfolio managers have supposed that
the historical volatility can be used as a proxy of the future volatility. However academic
research have proved that this indicator is not relevant of the future assets volatility
(historical volatility can be a good proxy in bull markets but not in bear markets where the
global volatility levels will increase more and faster), that is why they then used local
volatilities in their models and now the trend is to use stochastic processes to simulate future
volatilities.
As mentioned earlier, we not tend to use local volatility and usually the realized
volatility is expressed in 30 or 60 days volatility: the annualized standard deviation (in the
coming lines we will consider the standard deviation and the variance as equivalent but it is
important not to forget to take the square root to change the variance in volatility) of the daily
returns during the last 30 or 60 days - it is important to use the log returns in order to be time
consistent.
Concerning the formula we commented it in the previous section Volatility: Standard
deviation and Variance - Formula (1). It is important to precise how we average the distances.
We have seen that the historical volatility is usually expressed as an unweighted average of
the last 30 or 60 days using this variance formula (7):
(7) 2n =

1 n
(X n1 X)2

N 1 i=1

Xi is the value of the asset X at time i

Where

Where N is the number of studied periods and then the number of distances

You could have expected an N as a denominator and not N-1 but as we only use some
distances (a sample of distances) then we are not averaging the whole population and
then it is necessary to use N-1 as un unbiased estimator

In practice, you can simplify the formula (7) by taking two simple assumptions: the
daily mean return of a stock is small enough to be replaced by 0 and you can use m

14

instead of m-1, then you are not using an unbiased estimator but a maximum
likelihood one. Then we have (8):
(8) 2n =

1 n 2
U n1
m i=1

There is much more to say concerning the implied volatility. Here we need to do a
small digression to the Black and Scholes PDE (Partial Differential Equation), derived from
the Merton mathematical model. The B&S PDE is a very easy and commonly used way to
price options.
We will start with the pricing formula of a Call option (9). The put formula is easily
deductible from the call formula and the object here is not to present the B&S model:
(9) C(S, t) = N(d1 )S N(d2 )Ker(T t )

S
2
ln( ) + (r + )(T t)
K
2
Where d1 =
T t

Where d2 = d1 T t

Where N(.) is the cumulative distribution function of a standard normal distribution

Where T t is the time to maturity

Where S is the spot price of the underlying

Where K is the strike price of the option

Where r is the risk free rate (expressed in annual continuous compounding)

Where is the expected volatility (plus a premium?)

The implied volatility level is the volatility allowing the match between the actual

price of the option on the market (so-called the Mark-to-Market, or MtM) and the formula
result (3). Market operators use the implied volatility level (calculated as described above) as
a proxy of the expected volatility, which is the best traders forecast of the volatility during
the rest of the options life (the consistency of this hypothesis over time is function of the
hypothesis used but B&S model is based on flat volatility hypothesis).
For an illustrative purpose we present in exhibit 4 a analogy between the bonds and
the options in order to give a more empirical understanding of what the volatilities
(historical and implied) are when it comes to deal with derivatives instruments. The exhibit is
extracted from (Derman, 2003).

15

Exhibit 4: Analogy between Bonds and Options, Yields and Volatilities 3

Bonds

Options

Interest rates are the parameters people use

Volatilities are the parameters people use to

to quote bond prices.

quote options prices

Realized daily interest rates:

actual short-

Realized daily volatility: the actual volatility

term interest rates

of an index

Yield to maturity of a bond: the average of

Implied volatility of an option: the average

the future realized rates that make that bond

of future realized volatilities that make the

price fair. Its the implied yield based on

options price fair, based on Black-Scholes.

price.
Forward rates: the future realized rates,

Local (forward) volatilities: the future

moment by moment, that must come to pass

realized index volatilities, index level by

to make current yields of all liquid bonds

index level and moment by moment, that

fair.

must come to pass to make current implied

volatilities fair.

It is interesting to study the relation between the historical and implied volatility.
Indeed if implied volatility is a good proxy of expected volatility (we use here an if because
it is easy to question the B&S model hypothesis) it is thought that if implied volatility does,
indeed, contain information in forecasting future realized volatility, then implied volatility
may be useful in predicting stock market returns. Consequently the relation between historical
and implied volatility is the key to forecast the latter and define a rewarding trading strategy.
Christina Chui4 demonstrates by statistical inference:

The correlation between the historical and the implied volatility for the S&P100 (using
the VIX for the implied volatility and the HVOEX for the historical volatility) and
Nasdaq100 (using the VXN for the implied volatility and the HVNDX for the
historical volatility) at the 1% level of significance

3 In (Derman,
4 In (Chiu,

2003)
May 2002)
16

The non-significant difference between the historical and implied volatility means for
the two index at the 5% level of significance

She also observe in the data some widely accepted empirical regularities relating to
the time series behaviour of volatility: persistence effect, mean reversion, asymmetric
reaction of volatility to the market changes, global increase in volatility levels over
time
However if the means are not significantly different, the data compiled by Chui

present a implied volatility higher than the historical one. This empirical observation could
lead to the hypothesis of an overpricing of the options (due to the positive relation between
implied volatility and price). If Chui did not investigate the question due to the high level of
risk implied by naked sell of straddles (volatility sell), some more recent studies (Wallmeier
& Hafner, 2007) reveal a strong negative volatility risk premium: strong enough to generate a
positive return.

17

Volatility Index: example of the VIX

In this study we will focus on one major implied volatility index: the Chicago Board
Option Exchange (CBOE) Volatility S&P 500 Index (symbol: VIX). Introduced in 1993, it
measures the expected 30-days volatility implied by the SPX listed option prices. This choice
has been made based on the abundant academic research available on the index and for more
material reasons: it is the most traded volatility index avoiding to deal with major liquidity
limits in our study and due to the variety of derivative instruments available to get an
exposure to it. Actually the closest and more sensitive exposure we can have to the VIX is
through the 1-month forward.
Indeed if there are financial instruments giving an exposure to the VIX, by its
calculation methodology the index is not directly investable. The VIX is calculated by
averaging the weighted prices (by 1/K2, where K is the strike of the option) of SPX puts and
calls over a wide range of strike prices. Due to this calculation methodology (in particular the
weighting of each option price based on the strike), the puts contribute more to the index than
the calls: the smaller is K, the highest is 1/K2 and then the weight of this option in the index
calculation). Based on the same rational we can deduct that the more the put is OTM, the
more it will impact the index. The call/put impact split is approximately 1/3 for calls and 2/3
for puts (this result is obtained by measuring the sensitivity of the VIX to a 10% change in
volatility for the calls only and the puts only: the result is asymmetric and is in favour of the
puts).
If the VIX is not directly investable, the derivatives on the index know an exponential
increase in traded volumes as illustrated in the exhibit 5. The exhibit not only shows the
significant increase in traded volumes but also the timing of this boom: 2010 and 2011, just
after the last financial crisis. However the approach given to the VIX is different today than it
was in 2010. Then, the VIX was sold as a efficient hedge in case of market turmoil, but today
we know that this not true and the VIX is sold as a good diversifier. For example, in (BNP
Paribas, 2010) the VIX is presented with an embedded Delta to the S&P500 due to the
volatility skew of the options on the SPX. However there is no mention of the variability of
this delta (necessary in case of hedging).

18

Exhibit 5: Average daily volumes of traded VIX Futures and Options

Source: CFE and CBOE

In the Finance jargon the VIX index is known as the investor fear index and is a
contrarian indicator (cf. exhibit 6). As discussed previously, the implied volatility is a proxy
of the uncertainty and the calculation methodology makes it more sensitive to bear markets. It
leads the VIX to perform when the markets expect important losses. At this point the core
characteristic of the VIX we are looking for is its negative correlation, its inner negative delta
to the SPX: this negative correlation will provide us with the diversification effect.
The next question is obviously about the level of negative correlation in case of
important market change. The exhibit 6 shows that the global level of negative correlation in
crisis years (2008, 2010, 2011) has globally increased and then proves the efficiency of the
VIX in turmoil market. If we refer to the relation between asset correlation and diversification
effect studied in the section Correlation coefficient and diversification effect, it means that a
portfolio with an exposure to VIX will be well diversified even if the 2009 asset class
recorrelation happen again.
Previous studies (Dash and Moran in 2005 or Black in 2006) illustrate the potential
diversification benefits of adding spot VIX exposure to hedge fund portfolios. In addition to
the diversification benefits of spot VIX, they suggest that the skew and excess kurtosis of
many hedge fund strategies can be eliminated by a small long exposure to spot VIX (using the
VIX to reduce the fat tail effect). However we can regret that none of these studies indicate a
good entry point optimisation methodology. Moreover it is important to keep in mind the
important difference between the historical and implied volatility mentioned in Volatility:
historical and implied volatility due to the potential strong negative risk premium on
volatility (Wallmeier & Hafner, 2007) meaning a important cost of carry of VIX in portfolio.

19

Exhibit 6: The 10-Y daily returns and correlations of the S&P500 and VIX
Nega%ve'correla%ons'between'VIX'
and'S&P500'

VIX"Daily"close"

2004&

SPX$level$

1800"
1600"
1400"
1200"
1000"
800"
600"
400"
200"
0"

7/
31
/0
7/ 1"
31
/0
7/ 2"
31
/0
7/ 3"
31
/0
7/ 4"
31
/0
7/ 5"
31
/0
7/ 6"
31
/0
7/ 7"
31
/0
7/ 8"
31
/0
7/ 9"
31
/1
7/ 0"
31
/1
7/ 1"
31
/1
2"

VIX$level$

Prices$for$SPX$and$the$VIX$
90"
80"
70"
60"
50"
40"
30"
20"
10"
0"

2005&

2006&

!0.83&

!0.82&

2007&

2008&

!0.85&

!0.84&

2009&

2010&

2011&

!0.84&

!0.86&

!0.5&
!0.6&
!0.7&
!0.8&
!0.9&

!0.75&

!0.76&

!1&

SPX"Daily"close"

Correla4on&of&Daily&Returns&

Source: Bloomberg & CBOE Documentation

To conclude, for empirical reasons, the VIX will be our main source of volatility
levels and the underlying of the considered derivatives. Obviously the use of the VIX as
reference of implied volatility index involves, for our model, to use US assets in order to be
consistent: the S&P500 for the equity and US Bonds for the fixed income side. However the
readers interested in other markets, there is implied volatility index in most of the major
financial markets and they are investigated also like (Wallmeier & Hafner, 2007) with there
study on the DAX and the Eurostoxx500. The impossibility of investing directly the VIX will
also involve complication due to the instruments used to get exposure to it but we assume that
it is necessary to make this study useful for portfolio managers.

20

Volatility: from the Smile to the Skew

One of the limits of the Black & Scholes model is commented here. Actually B&S
predicts that the implied volatility is a constant function of the strike or the time to maturity. If
this hypothesis was almost true before the 1987s crash, it is absolutely no longer true. The
so-called volatility smile is the characteristic variation of implied volatility in relation to the
strike and time to maturity. It appeared after the 1987 crash and is inconsistent with the
Black-Scholes model - in this model we should have a flat implied volatility.

Volatility and rate of return

There are widely accepted reasons of this volatility skew. Mark Rubinstein studied the

volatility skew first (and probably discovered this irregularity in the smile). He suggested a
crash-o-phobia phenomenon5. As the skew is observed since the crash of 87, he suggests
that the markets fear another crash and price this event by charging more implied volatility on
low strikes. The empirical analysis confirms this hypothesis as a bearish market makes this
skew steeper and a bullish market less steep. Because the traders have to sell when the stocks
go down to stay hedged and because at those levels the stop loss orders fast the market drop,
this empirical observation makes sense.
Another explanation is related to trading strategies used by market agents and there
risk aversion (a development to the crash-o-phobia hypothesis). When a stock fall, the
demand, and thus the price for it will decline but demand for puts on the stock will increase
(resulting in short-sales for delta-hedge by market operators). This rational suggests that
investors indirectly set the level of implied volatility, as investors demand for calls and puts
set prices, and these prices, in turn, are used to imply the level of the implied volatility
indicators.
Finally a more fundamental explanation involves the leverage of the equity. When the
equity value declines, the leverage ratio of the companies increases and therefore makes the
equity riskier and sensitive to the market moves (cf. levered beta concept). The consequence
is obviously a higher implied volatility. This observation makes the implied volatility a
contrarian indicator, as it will spike more frequently on bearish markets than in bullish ones.


5 Mentioned in (Rubinstein,

1994)
21

Volatility and Strike

Exhibit 7: From the volatility smile to the skew
Vola,lity(smile((

Vola,lity(skew(
Equity'op*ons'

Implied(vola,lity(

Implied(vola,lity(

FX#op&ons#

Strike(

Strike(

In the case of an equity underlying, we do not have a volatility smile (first graph of the
exhibit 7) but a downward sloping curve also called volatility skew (second graph of the
exhibit). This asymmetric smile of volatility is the result of a non-lognormal probability
distribution of the underlyings return (remember that the Black and Scholes pricing model
involves a lognormal distribution of the assets prices). More precisely the volatility skew
presented in the second graph of the exhibit 7 is the result of a positively skewed distribution
of the underlyings return: this skewness will involve a heavier left tail and a less heavy right
tail, in other words a higher probability of loss.
The consequence of this probability distribution is that a deep-out-of-the-money call
will have a lower price than with a lognormal distribution (as the surface under the curve after
the strike is smaller than with the lognormal bell). The price difference will result in a reduced
implied volatility. This rational also works with the puts. If you consider a deep-out-of-themoney put, then the option pays off if the underlying price is below the strike. As this surface
is bigger than with the lognormal distribution then the price will be higher and consequently
the implied volatility also.
If we make the assumption that the previously mentioned positive risk adjusted return
of shorting implied volatility, it means that the skewness of returns is too high in comparison
to the actual volatility of markets (do not forget that the implied volatility is used as a proxy
of the expected volatility). Nassim N. Thaleb could answer with its barbell strategy: pay the
VIX premium can appear as a loss but in case of Black Swan in the equity market? Protection
is a cost until it protects you, then it is an asset.

22

Volatility and Time to Maturity

Exhibit 8: The mean-reversion of the volatility

Vola,lity(and(Time(to(maturity(

Implied(vola,lity(

All#op&ons#

Time(to(Maturity(

Short-term volatilities are higher than long-term ones. This is true for both historical
and implied volatility (which is normal due to the relation between the two) and can be
observed in our long term VIX spot graph (cf. exhibit 6). It suggests the empirically observed
mean-reverting property of the volatility. In other words, the instantaneous volatility (the limit
of the implied volatility of an at-the-money option as its time to maturity approaches zero)
tends to be flat.
Samuelson did a similar hypothesis related to the futures, the so-called the Samuelson
Hypothesis. In 1965, he said: it is a well known rule of thumb that nearness to expiration
date involves greater variability or riskiness per hour of per day or per month than does
farness. This hypothesis involves:

The mean reversion of volatility suggests that the value of the volatility in the long run
is equal to the average/historical volatility level. In markets where Samuelson
Hypothesis holds, the historical volatility is good proxy for the long-term expected
volatility level but it does not say anything about the short-term volatility

It has a impact on asset pricing as the futures will be affected via the margin calls
(positive function of volatility), the more volatility we have the more the traders will
have to post collateral to hedge there positions. This collateral is obviously costly. The
options will be affected via the hedging costs, if the traders price higher volatilities
near the maturity date, then the options will be more expensive.

23

Exposure to the VIX via swaps, futures, options

In this chapter we will present different wrappers allowing an exposure to the
volatility (via variance swaps) and to the VIX index (via VIX futures and options). We will
start with the var-swap because it is considered as the purer instrument to get an exposure to
the volatility. Then we will study the VIX Futures and Options because they are easily
tradable in the CBOE. If these products are not the only ones to give an exposure to the
volatility, they are the more widely used (cf. Volatility Index: example of the VIX) and will
allow us to get factual information and market data.

Variance Swaps (so-called Var-swaps)

A volatility swap allows the investor to bid on the increase (by taking the long
position) or decrease (by taking the short position) of the volatility, more precisely the
variance of the underlying. We consider K, the strike (solved in order to make the present
value of the contract equal to 0), the buyer will receive the Vega notional (because it is
expressed in USD) for each Vega (percentage point of the volatility) above the strike and pay
the Vega notional for each point below. The payoff formula is:
2
(10) Payoff = N var * ( realized
K2)

Where

N var is the notional allowing the contract to pay approximately the Vega

amount for each volatility point

N var =

N vega
and N vega is the Vega notional. To demonstrate
2K

this we can consider realized = K +1 (as we want to study the

impact of 1 percentage point, 100bp, of the realized volatility on
the payoff) and solve the equation:
2
Payoff = N var * ( realized
K2)

N vega "
* #(K +1)2 K 2 $%
2K
N
= vega * [ 2K +1]
2K
1
= N vega +
2K
=

And

1
is negligible in front of N vega
2K
24

2
Where realized
is the realized variance of returns, or the squared volatility

Where K 2 is the squared strike (because the strike is expressed in volatility)

A var-swap also needs to define in the term sheet the following parameters:

The source of information (as mentioned earlier in the chapter

Volatility: Historical and implied volatility, there is different ways to
calculate the realized volatilities)

Observations frequency (we can have no move between to observation

points but important movements between the two, cf. Volatility and
time to maturity relation)

Annualization factor

Formula used for the standard deviation

Usual assumptions with var-swaps:

252 Business days per annum as annualization factor (explaining the

famous 1% daily vol = 16 on the trading floors, this is the result of

252

Daily mean return = 0 (in order to allow additivity of the contract, 3

month var-swap + 9 months var-swap in 3 months = 1Y var swap).
This is typically a point to consider as this assumption will impact the
estimated realized volatility

Convexity of the payoff:

Exhibit 9: Contrary to volatility, variance offers convexity
Convexity&of&var3swaps&in&vola)lity&
(with&strike,&K=24)&
5#
4#

Payo&

3#
2#
1#
0#
!1#

0#

10#

20#

30#

40#

50#

!2#
!3#

Vola)lity&
Vola-lity#payo#

Var!swap#payo#

25

The exhibit 9 illustrates how the payoff of a variance swap is convex in

volatility. This means that an investor who is long a variance swap (i.e.
receiving realized variance and paying strike at maturity) will benefit
from boosted gains and discounted losses. This bias has a cost reflected
in a slightly higher strike than the fair volatility, a phenomenon that is
amplified when volatility skew is steep. Thus, the fair strike of a
variance swap is often in line with the implied volatility of the 90% put

VIX Futures

VIX products are a second way to get an exposure to implied volatility. Indeed, if the
var-swaps are replicated via a portfolio of options on the studied asset (e.g. a var-swap on the
S&P 500 is replicable via a portfolio of options on the index), the VIX products work
differently. They allow an exposure to the VIX, which is a measure of the implied volatility of
the S&P 500. Basically, if we could invest on the spot VIX, the performance at maturity of
the VIX and the squared root performance of the var-swap could be the same.
In this context, the first products are the VIX futures; they started to trade in March
2004 at the Chicago Futures Exchange (ticker: VX).

Multiplier: USD1000 and USD100 for the mini-VIX futures

Underlying: VIX SOQ (i.e. Special Opening Quotation). This

procedure returns the VIX forward level for the 30 days after the
settlement (based on the options available on the SPX on the settlement
date). Please note that this procedure does not reflect only the expected
volatility in 30 days but the whole term structure during the period.

Pricing: futures are quoted in points with a two decimals precision and
each point is valued at the multiplier

Price intervals: min. 0.05 points (corresponding to USD50 for the

futures and USD5 for the mini-VIX futures)

Settlement style: contrary to other futures underlying, VIX futures can

only be settlement by a cash payment

26

Settlement: The amount of this payment will be equal to the final

settlement VIX future value times the multiplier and has to be done the
following day (the clearing house system is used). Please not that the
futures trade on the expected level of the VIX and consequently there is
no strict push-to-spot effect but only a convergence to the spot. It
means that when the future settle, the level will probably not worth the
spot VIX due to the mean-reverting properties of it.

When an investor wants to maintain its exposure, he can roll his position (close its
present position and buy a new one in a later term). The problem with a long volatility
exposure is the frequent steep contango on the VIX term structure and the consequent cost of
this contango for the investor.

VIX Options (ticker: VRO)

The second wapper offered by CBOE are the options in 2006. You can find quotation
and buy VIX calls and puts on the market. The options on VIX have a particular pricing and
settlement in comparison to other options, there is no nominal but a multiplier, like for
indexes, the premiums and payoffs are function of this multiplier. The fundamentals
characteristics of these options are:

Multiplier: USD100

Strike intervals: min. 2.5 points

Available strikes: in/at/out of the money strikes are available with a

dynamic range (new strike can be issued if necessary)

Premium quotation: premium are in points and each point worth the
multiplier

Exercise style: European (can only be exercised at expiration date)

Settlement: The exercise-settlement value for VIX options shall be a

Special Opening Quotation (SOQ) of VIX calculated from the sequence
of opening prices of the options used to calculate the index on the
settlement date. Exercise will result in delivery of cash on the business
day following expiration. The exercise-settlement amount is equal to
the difference between the exercise-settlement value and the exercise
price of the option times the multiplier

27

The strength of VIX options are the leverage it allows in our exposition to the VIX
and the easy way it works. However if the value at expiration date is easy to understand, the
value of the option between the inception date and the expiration date is not equal to the
payoff value. The value at anytime is the result of different impacts and the global impact of
the different sensitivities can even engender a drop of the option price on the secondary
market when the VIX is in our favour but this is also true for puts protection so portfolio
managers should be able to deal with it.

28

Risk adjusted return: Sharpe ratio and some others

Sharpe ratio

The Nobel laureate William F. Sharpe gave its name to this ratio allowing a measure
of risk-adjusted performance. Please note that the Sharpe index refers to the same indicator.
The idea here is to measure how much extra-return a security or portfolio gives me for each
unit of risk. The Sharpe ratio formula is:
(11) Sharpe.ratio =

Where r p is the expected portfolio return

Where

rf

Where

r p rf

p

is the risk-free rate

is the standard deviation of the portfolio

The strength of this ratio was the possibility to compare portfolios easily (as all the
information we need is directly and easily computable from the observed series of return).
Indeed, two portfolios can have different returns but the real question is how much risk (and
we all know risk is money) the extra-return will cost? Obviously the best investment is the
one with the higher Sharpe ratio, meaning that for each unit of risk the portfolio provide a
maximum extra-return to the risk-free rate, and a negative result will mean that risk-free
securities (or portfolio) is the best.
However a major weakness of this indicator is it requires normally distributed returns
(otherwise the standard deviation could be a highly inefficient measure of risk). Indeed we
have presented the standard deviation we commented that a major weakness of this measure is
the insensitivity to the sign. Therefore applied to a distribution of returns, the standard
deviation gives us accurate information only if the distribution is symmetrical to the mean.

29

Lelands Alpha and Beta

Lelands indicator where presented in an article with a very meaningful title Beyond
Mean-Variance: Performance measurement in a non-symmetrical world, (Leland, 1999),
based on an interesting assumption: market returns are normal but not securities or portfolios
returns. Leland presents an enhancement of the Jensen Alpha (as the Jensen Alpha is based on
the CAPM and this model suppose that investors only care about mean and standard deviation
and by that rejects the eventual preference for positive skew and kurtosis) allowing the
preference for low kurtosis and positively skewed distributions.
To determine the Lelands Alpha we first need to compute the market price of risk
(noted b here) which, if market returns are normal, worth:
(14) b =

log [ E(1+ rmkt )] log(1+ rf )

var [ log(1+ rmkt )]

Where

rmkt is the return of the market (used as benchmark)

Where

rf

is the risk-free rate

From that point we can compute the Lelands Beta:

(15) Leland =

cov "#rp , (1+ rmkt )b $%

cov "#rmkt , (1+ rmkt )b $%

Thus, the Lelands Alpha:

(16) Leland = E !"rp #$ Leland !" E(rmkt ) rf #$ rf
Leland concludes as following: for assets or portfolios whose returns are jointly
lognormal with the market, the differences between the correct beta and the CAPM beta are
small and the mismeasurement of alpha is similarly small. For portfolio or asset returns that are
highly skewed, the correct beta differs substantially from the CAPM beta. Thus, using the correct
beta is critical for correct performance measurement of investment strategies that use options,
market timing, or other dynamic strategies.

30

Stutzer ratio

Michael Stutzer in (Stutzer, 2000) presented also a new measure of risk-adjusted

returns robust to non-normal distributions of returns. For him, a portfolio manager motivation
is to exceed the returns of a particular benchmark (which is confirmed by the remuneration
policy of asset managers and in particular hedge-fund managers). Provided that his portfolio
expected return is greater than that of the benchmark, the probability to underperform the
benchmark decays over time to zero. Provided that we would like to be sure of that, we can
use the rate at which the probability of underperforming decays to zero as a measure of the
portfolio manager performance. In other words, the faster the portfolio manager reduces our
risk to underperform the benchmark the better he is. Stutzer captures the information statistic
via the following formula:
)
# 1 T r &,
(12) I p = Max + log % e t (.

$ T t=1 '*

Where

rt

is the excess return of the portfolio on the benchmark over time (e.g. we

measure the outperformance of the portfolio on the market)

I
Where is chosen to maximize p . In this study we have defined this factor via an

Excel macro computing 1000 iterations. The calculation of this indicator is highly
calculation power consuming (e.g. 10 minutes on a Intel core i5 1.7Ghz). Which
probably explain why this indicator is not much popular.
(13) StutzerIndex =

r
r

2I p

Where r is the mean excess return

Where r is the absolute value of the mean excess return

Actually the strength another strength of the Stutzer index is that if the distribution is

normal, and then it will worth the Sharpe ratio! Otherwise the Stutzer index will penalize high
kurtosis and negative skewness.
Indeed, regarding the Sharpe ratio we will have:
Ip =

Where

1 2
p and consequently StutzerIndex = p
2

is the Sharpe ratio of the portfolio

31

III Methodology
The goal of this research paper is to try to determine whether or not the volatility can
be considered as a new asset class and if an investment strategy using it to diversify a
portfolio of risky assets will allow a better risk-adjusted return (in particular in crisis periods).
The underlying hypothesis is that the negative correlation of volatility to the other asset
classes (observed in exhibit 3 and 6) will allow a better diversification but also an efficient
protection against Black Swans. This research will require an inductive approach: we will
design different portfolios and analyse them thanks to risk-adjusted indicators in order to
determine what investment strategy has the better risk adjusted return profile.

Description of data

Equity exposure:
The Standard and Poors 500 Index is widely regarded as the best single gauge of the
U.S. equities market, this world-renowned index includes 500 leading companies in leading
industries of the U.S. economy. Although the S&P 500 focuses on the large cap segment of
the market, with approximately 75% coverage of U.S. equities, it is also an ideal proxy for the
total market. Then, we have decided to consider an exposure to the SPX for the equity pocket
of our portfolio.
At this stage we faced a difficulty to manage the dividends paid by the index as the
SPX is adjusted to reflect the payment of the dividends to the investors (originating an
underestimation of the returns as our portfolio strategy suppose to reinvest them). Please note
that we passed through this difficulty by using the S&P 500 Total Return index. The Total
Return version of the SPX simplifies the management of the dividends by making the
hypothesis that the investor reinvests the dividends (after tax, based on the hypothesis of an
US investor) in the SPX. This hypothesis fits better to our model and do not impact
significantly our monthly rebalancing strategy. Our SPXTR time series are based on the dailyclose returns extracted from the CRSP (Center for Research in Security Prices) via the
Wharton Research Data Service.

32

Volatility exposure:
As mentioned earlier, this study will focus on the VIX as implied volatility indicator.
This is to be consistent with the equity pocket of our portfolio but also because the VIX
presents major strengths: it is investable, has a large span of securities using it and presents a
good liquidity. Please remember that if the spot VIX is not directly investable, we have seen
in Exposure to VIX via swaps, futures and options what the more frequent VIX instruments
are.
We have decided here to use VIX futures: in particular we have used the S&P 500
VIX Mid-Term Futures Index. Indeed this index offers to investors directional exposure to
volatility through publicly traded futures markets, and seeks to model the outcome of holding
a long position in VIX futures contracts. This index allowed us to integrate a large part of the
transaction costs for the volatility pocket and to integrate the rolling strategy which is out of
our scope but represent a real issue with VIX futures: as commented earlier, the steepness of
the volatility term-structure generates an important rolling cost. For the same reason we have
decided to use the VIX mid-term futures instead of the VIX short-term futures (the rolling
cost is less important as the steepness of the slope is decreasing for the farer terms).
The liquidity is important for our study because it is measured via the bid/ask spread
and we have not integrated it in our model. The more liquid is the index, the smaller is the
bid/ask spread, the smaller is the over performance implied by this hypothesis. Consequently,
as the VIX presents a good liquidity (as shown in exhibit 5), it avoids us the difficulties and
transactions costs that a liquidity management could imply for the investors (this good
liquidity parameters have allowed us to suppose a reduced bias in the study by not including
the bid/ask spread in the returns). Note that we did not include it because we have not found
the appropriate time series. Our VIX time series are the daily-close levels extracted from
Bloomberg.
Bonds exposure:
With the pari passu rational about the coherence between the asset classes, we
needed to use US bonds for the fixed income exposure. The idea was to avoid a debtor
picking bias and consequently we have decided to choose US Government 10Y Bonds to
bench the bond asset class performance (which is a classic choice for this asset class). The
10 years maturity is due to our investment horizon, if we are analysing a long-term period, it
makes sense to use long-term maturities. Moreover, it allows us to maintain an important

33

duration in the portfolio without a complex bond investment strategy. The 10 years bond
yields are extracted from the U.S. Department of the Treasury database.
To finish, all the levels, prices and yields are based on daily-close time-series covering
an almost eight years period starting in January the 1st 2004 and ending in August the 31st
2012. The time horizon was limited in the past by the creation of the firsts derivatives
instruments on the VIX.

Analysis methodology

If the academic and theoretical aspects are part of our investigations, this study targets
to be useful for a finance industry professional with no experience in volatility products. The
thesis should be an answer to:
How volatility, if considered as a new asset class, will impact in terms of return
and risk a portfolio of risky assets?
The first hypothesis involved in this paper is that volatility is an asset class. But
volatility is most widely known as a measure of risk, that is why the first step is explain why
we can consider that the volatility, whatever the underlying is, can be considered as an asset
class meanwhile there are products allowing exposure to it. We tried in the previous Asset
classes section of this paper to define a framework allowing us to define if a set of securities
is an asset class or not. The framework we have defined takes into account:

The economic sense of the supposed asset class

The tradability of the securities (this is a very empirical approach but

really making sense to us. Moreover this approach raise other
interesting questions:

The question of returns measure

The existence of the securities and the market access

The liquidity question

The homogeneous risk and return profile of the considered securities

This hypothesis is more an academic/qualitative question. Answer to it will not have

an impact on the financial market industry and the implied strategy. Some
authors/professionals will consider this hidden asset class like a sub-asset class some others
like an investment strategy etc. The debate is open and our goal is not to close it but to design
a tool allowing the synthesis of what we have found on the topic.

34

The second hypothesis is that volatility is a good portfolio diversifier and improves the
return of a portfolio for a given level of risk. Our approach here is to simulate different
portfolios (with different assets exposure and different weights for each asset classes). We
have used 3 asset classes: volatility, equity and bonds. First, we will analyse two traditional
portfolios and then test different volatility exposure levels. The portfolio will be rebalanced to
maintain the chosen asset class weights the first working day of each month.
To resume the properties of our portfolios will be:

Traditional portfolio 1: 100% invested in 10Y bonds

Traditional portfolio 2: 100% invested in equity (in the SPXTR)

Traditional portfolio 3: 60% equity in SPXTR and 40% in 10Y bonds

For the volatility exposure, we will try a 5% and 10% long asset
allocation to the VIX trough the S&P Mid-term Futures Index

The transaction costs are not captured in the study due to the absence of
information but could be easily captured via a simple bid/ask spread
(not computed here due to the lack of information)

The weights in the portfolio are arbitrary and based on different studies we have used
for this paper. The reason is that during crisis periods the only performing asset are the
volatility products and the optimisation gives us a 100% of VIX products, which is a nonsense and/or out of the scope of our study. Then we will compare the risk and return profiles
of the different portfolios over the long run.
The third hypothesis is about the efficiency of using variance to hedge a portfolio
against a Black Swan. Here we will suppose a dynamic exposure to the VIX in order to avoid
paying the negative risk adjusted premium of the volatility. The gearing optimization is, in
our opinion, out of the scope of this study and consequently we will consider a flat 10%
exposure to the VIX based on the distance between a moving-average of the VIX and the spot
VIX to trigger the exposure. Then we will implement the same analysis of the risk and return
than for the second hypothesis.

35

IV - Results
Hypothesis 1: Volatility is a new asset class

Hypothesis origin

Asset class and diversification are two portfolio management concepts useful when it
comes to control the risk carried by a portfolio (please find more details on these two concepts
in the previous sections Asset classes and Correlation and diversification effect). For years,
markets have split the two concepts and many industry professionals have considered, for
example, a smart stock picking were enough to protect a portfolio against systematic risk (by
opposition to the idiosyncratic risk which is not diversifiable). However if this diversification
scenario, based on a single asset class, may be rewarding in terms of return, it also bears
hidden risks like a potential increase in assets correlation or a change in the risk-adjusted
return.
They have based their diversification on a simplistic interpretation of the
diversification as described on the exhibit 2: if I have enough different securities in my
portfolio, with a good allocation between smid and large caps, with a mix between defensive
and pro-cyclical stocks and an exposure to international equity, then Im diversified and I
receive the equity required rate of return. However in a single asset class, it has been proven
that it exists some hidden correlations between securities and these correlations became more
visible in bear markets (when you need the most the diversification benefits!). Moreover the
following exhibit 10 illustrates the same phenomenon between many asset classes during the
financial crisis.
Exhibit 10: Asset class correlation in normal and crisis periods
Exhibit'10'*'Asset'class'correlations'of'2004'to'2006'(2007'to'2008)
Equity
FY04/to/
FY06
Equity
////1.00
Bonds
////0.02
High/yield/bonds ////0.51
Hedge/funds
////0.77
Commodities
///(0.22)
Private/equity
////0.77
Real/Estate
////0.56

FY07/to/
FY08
////1.00
////0.22
////0.87
////0.80
////0.52
////0.84
////0.85

Bonds

High/yield/bonds

Hedge/funds

Commodities

Private/equity

Real/Estate

FY04/to/ FY07/to/ FY04/to/ FY07/to/ FY04/to/ FY07/to/ FY04/to/ FY07/to/ FY04/to/ FY07/to/ FY04/to/ FY07/to/
FY06
FY08
FY06
FY08
FY06
FY08
FY06
FY08
FY06
FY08
FY06
FY08
////1.00 ////1.00
////0.39 ////0.40 ////1.00
///(0.01) ////0.18 ////0.54
///(0.06)
0.00 ///(0.07)
////0.28 ///(0.01) ////0.61
////0.46 ////0.31 ////0.44

////1.00
////0.74
////0.55
////0.80
////0.91

////1.00
////0.06
////0.77
////0.47

////1.00
////0.80
////0.75
////0.63

////1.00
///(0.23)
///(0.19)

////1.00
////0.65
////0.44

////1.00
////0.61

////1.00
////0.85

////1.00

////1.00

36

The investigated hypotheses explaining the increasing correlation levels are in

particular:

Between international stock exchanges: the globalization and

increasing integration of economies are favouring the multi-national
companies and this phenomenon linked to the free movement of capital
is correlating equities around the world. The stock exchanges mergers
and concentration process to ease the international market access to
investors is probably in cause as well

Equities and bonds: if these two asset classes were traditionally the
mainstay of asset class diversification, it is possible that the increasing
relationship between investment banking and structured financing
could be the cause. Another hypothesis is based on the development of
the hedge fund industry and the growing success of the cross-asset
financial products. A loss in a position could generate a cash pulling via
the margin/collateral calls and force to close other positions and affect
the related asset classes

The research on these hidden risks has allowed the creation of securities giving an
exposure to them. Here comes the divergences: do we simply have to consider these sets of
securities as derivatives because their value is derived from other securities or we have to
try take into account the specific economical sense of these securities and finally split the
derivative family into different asset classes. In other words, the hypothesis we are doing
here is the prominence of the substance over the form.

Demonstration of the hypothesis

As mentioned in the methodology, in order to test this hypothesis, we have thought in

the section Asset Classes a framework defining a set of criteria we have found during our
research. The framework has been described earlier and we will not present it again, we will
focus here in applying it to the implied volatility in order to test whether or not it can be
considered as an asset class, a hidden asset class where the derivatives only allow an exposure
to it.

37

We have decided to consider the implied volatility and not the historical volatility for
two main reasons:

In our opinion financial asset have to be oriented to the future (as most
of them are valued to the actualized value of future cash flows).
Consequently, we consider the implied volatility (which, as we have
demonstrated in Volatility: Historical and Implied volatility, is a good
proxy of the expected volatility) is the more appropriate volatility for
this hypothesis

We also do it in order to be consistent with the two following

hypothesis of this research paper: analysing the impact of adding VIX
exposure in different portfolios (and we have seen that the VIX is a
measure of the implied volatility of the SPX)

Criterion 1: The economic sense of volatility

If we have to analyse the philosophy of volatility products and in particular the
philosophy of the VIX, then we have to remind the relation between the VIX and SPX. We
have seen that the VIX, a measure of the SPX implied volatility, is also called the market fear
gauge. This nickname of the VIX resumes the economical sense of volatility: it measures
the expected short-term level of risk on the market. The exhibit 6 presented in the previous
pages illustrates the negative relation between the two indexes: the VIX has a negative inner
delta to the SPX. Moreover the way the VIX is calculated makes the index not symmetric to
the SPX returns, it is more sensitive to market downturns: where the risk really is.
The underlying question then is the economical sense of the SPX. As commented
earlier, the S&P 500 Index measures the changes of the Top500 market caps in the US taking
into account the different sectors of the economy. Today, the index covers more than 75% of
US equities and is the most important equity index in the country (more than the DJIA which
presented the defect of being equiweighted and only presenting the Top30 market caps). By
giving an economical sense to the VIX (and the implied volatility in general), as a meaure of
risk of the underlying, we are assuming that the SPX does reflect the economical health of the
country. At this point we have a debate between people saying that the markets do not
measure the economic health and the opponents saying it does.

38

In our opinion this debate is out of the scope of this research paper and in particular in
this part of the paper and we will only argue with a Warren Buffet quotation6 the market
value of all publicly traded securities as a percentage of the countrys business that is, as a
percentage of GNP has certain limitations in telling you what you need to know. Still, it is
probably the best single measure of where valuations stand at any given moment. And as you
can see, nearly two years ago the ratio rose to an unprecedented level. That should have been
a very strong warning signal.
At the end of the day, the market value of a company is supposed to be equal to the
present value of the future cash flows it will generate and an equity index like the SPX
measure the change of this sum of present values. If the market can be irrational and/or
manipulated, in the long run, they do reflect the health of economy. As a consequence, if the
SPX has a strong economical sense, then necessarily the implied risk of it, the VIX, has
also an economical sense: it measures the vision of the market on the market/economy
health. However it is important to note that there is a potential limitation to the hypothesis
here: the underlying must have a strong economical sense to make this hypothesis consistent
based on our framework.
Criterion 2: The tradability of the securities including:

The question of returns measure

Here we have to distinguish two kinds of instruments: the publicly traded securities
and the securities traded OTC. In the first category we will have the VIX futures, options and
ETN. For this category of securities, there is no problem of returns measure. The VIX is an
index with a public calculation methodology and the instruments mentioned have a value
based on the VIX times a multiplier. The returns of that category of securities are not subject
to any calculation difficulty.
For the OTC securities, the securities are made and priced on demand. In this case the
bank and the client can agree on a particular return calculation. Moreover, for the variance
swaps in particular, the calculation of the realized volatility can be subject to discussion.
Different formulas can apply as commented in Volatility: Historical and Implied volatility
(e.g. the difference between the formula 7 and 8). The banks also smooth them margins
engendering a difference between the actual price of the product and the expected price.


6 In the Fortunes, an interview of Carol Loomies

39

In the mean time this differences have a limited impact on the payoffs of the securities
and are more subject to impact the rounding and the price of the products on the secondary
market than the approach of the return measure. As a consequence, if there are some
discrepancies in return calculations between securities, the return calculation is feasible and
globally homogeneous.

The existence of the securities and the market access

The principal products allowing an exposure to volatility have been presented in the
previous section Exposure to the VIX via swaps, futures, options. The question of the
existence and tradability of the securities is then answered in the state of the art of this
research paper. However we have to note that the complexity of the product reduces the
span of the potential clients and market regulations may require an accreditation of the
investors.
The remaining question is about the market access: this question is closely related to
the previously mentioned point of investor accreditation. We are here talking about very
specific products and consequently they are not as easy to access than equities or even bonds
but the CBOE is a large stock exchange with large coverage and lot of brokers allow at good
price a market access. Consequently we can then consider that the market access is good
and not difficult for market operators allowed to trade such products.

The liquidity question.

As mentioned earlier we have decided to do not consider the question of the liquidity
in this study. However the figures of the exhibit 5 shows a large and growing volumes for
volatility products.
Criterion 3: The homogeneous risk and return profile of the considered securities
The first question here is to know if the securities we are considering for an exposure
to the implied volatility. As mentioned earlier we do not have data series for options and
swaps but it is interesting to study as an example the different terms strategies for futures. The
exhibit 11 illustrates how different are the returns over the long term depending of the chosen
term however the profile (i.e. the directionality) of the series are similar. The difference
between the series are essentially due to the rolling cost.

40

Exhibit 11: Returns of different VIX futures term

VIX$Returns$
!800.00!!
!700.00!!
!600.00!!
!500.00!!
!400.00!!
!300.00!!
!200.00!!
!100.00!!
!"!!!!
1/3/06! 1/3/07! 1/3/08! 1/3/09! 1/3/10! 1/3/11! 1/3/12! 1/3/13!
S&P!500!VIX!ST!Futures!Index!

S&P!500!VIX!MT!Futures!Index!

VIX!Spot!

If we have seen with the previous exhibit that we can have different returns but a
common directional exposure to the VIX, do these securities have a homogeneous risk/return
profile? If this question is close to the previous one, we will focus here more on the payoff.
Indeed what make the shares and bonds common families of asset; it is also the common
philosophy of the products (and not only of the underlying). Part of it is the payoff. At this
point we are touching a limit of our hypothesis: as we have different derivatives products
allowing an exposure to the implied volatility with extremely different philosophies (the VIX
futures pays the expected volatility when the var-swaps at maturity pays the different between
the implied and realized volatility). This point avoids considering all volatility products as
a homogeneous asset class but this result, in our opinion, only weakens our results and
not invalidates them.
As a conclusion, volatility (for the purpose of this study the SPX volatility) satisfies
most of the defined criteria required by our framework and then we can conclude that the
volatility of the major indexes can be considered as a de facto new asset class. We are
convinced that if the wrappers can weakens our conclusions, at the end of the day the driver
of the products returns (and underlying risk) is the level of risk measured by the market:
which is a common base to all these products. Then we cannot reject this first hypothesis
and it drives us to our second hypothesis: what is the impact of this new asset class on a
traditional portfolio?

41

Hypothesis 2: Volatility improves risk-adjusted returns

Hypothesis origin

As commented earlier, the volatility presents a negative inner delta to its underlying.
This negative correlation between the two could allow a portfolio manager to consider the
volatility as an equity hedge. Unfortunately, in the exhibit 6, we have highlighted a varying
level of correlation between the VIX and the SPX. This particular relation was also observed
in other indexes as demonstrated in (Wallmeier & Hafner, 2007) with the Deutscher
Aktienindex (DAX) and EuroStoxx50 index (ESX). Based on this observation, using the
volatility as an equity hedge is challenging, as the correlations between the implied volatility
index and the underlying index are conditional and not stable over time (cf. exhibit 6), but a
selectively applied long volatility position may provide significant diversification benefits,
particularly in times when the diversification benefits of other assets break down, such as in
the last two quarters of 2008.7
The question here is to measure this gain, if there actually is a gain, to invest part of
the portfolio in VIX instruments? But in finance industry we know (or should know) that
gains come with risks and then it is important for us to determine the impact on the
distribution of the portfolio return.

Demonstration of the hypothesis

Step 1: Determine a benchmark

As presented in the methodology, at this stage we have decided to model classic
portfolios to get an initial benchmark to compare in a second time the VIX impact.

Full bond portfolio: we have invested the portfolio nominal in a US

10Y bond with a total return assumption: we reinvest in bonds the
coupons received and simulate the impact of the yield change over
time. Please note that we do not have considered the management of
the portfolio duration here

7 Quotation from (Szado,

2009)
42

Full equity portfolio: we have invested the portfolio nominal in the total
return SPX. This allows getting an equity-diversified portfolio

Mixed portfolio: supposing 60% of equity and 40% of bonds, which is

based on the same assumptions than the two previously presented
portfolios
Exhibit 12: Classic portfolio returns and distributions

Returns')distribu-on)

Por$olios(performance(
0.12"

1400000#

0.1"
0.08"
0.06"

1000000#

0.04"

Mix#

1/
3/
11
#
1/
3/
12
#

1/
3/
09
#
1/
3/
10
#

1/
3/
06
#
1/
3/
07
#
1/
3/
08
#

0"

Full#Equity#

Full#Bonds#

)5.4%"
)4.8%"
)4.2%"
)3.6%"
)3.0%"
)2.4%"
)1.8%"
)1.2%"
)0.6%"
0.0%"
0.6%"
1.2%"
1.8%"
2.4%"
3.0%"
3.6%"
4.2%"
4.8%"
5.4%"

0.02"

600000#

Mix"

Portfolios)modelling)/)Distribution)analysis
Mix
Full.Equity
Return
0.02%
0.03%
St.dev
0.79%
1.48%
CAGR
5.56%
7.11%
St.dev.p.a
12.54%
23.51%
Kurtosis
...........7.10 ...........3.68
Skewness
...........2.74 ...........2.07
Sharpe.ratio
...........0.41 ...........0.29

Full"equity"

Full"bonds"

Full.Bonds
0.02%
0.65%
4.62%
10.36%
...........6.95
...........2.65
...........0.41 (8)

Note: The exhibit returns the following ranking (based on the Sharpe ratio and skew): 1st Mix, 2nd Full
Bonds, and 3rd Full Equity

To begin please note that these results come from a sample of 1,698 observations of
returns on a daily basis between January, 3rd 2006 and September, 28th 2012. This large
sample allows us to consider it as significant in regard to the analysed underlying. This is
particularly true when we know that the VIX futures started to trade in 2004.

8 The risk-free rate is the average 3 months US Treasuries rate over the period.

43

Another important note is about the rebalancing date. At this stage we have tried to
analyse the impact of different dates on the mixed portfolio (trying the 2nd and 3rd Monday of
the month) without any substantial difference. Indeed the idea was to be sure we are not
biasing our model by choosing an arbitrary rebalancing date (the 1st Monday of each month).
The bigger impact we have found is on September, 16th 2011 with a difference of USD27,243
for a portfolio value ranging from USD1,189,707 and USD 1,216,950 (c. 2.3% of the
nominal). We have decided to mention this spread for each portfolio but not to analyse each
underlying portfolio as we consider this spread negligible (it is 2.3% in 6 years, the risk free
rate).
The first observation we can do based on the exhibit 12 is the non-normal distribution
of the returns. We all know that for years the finance literature has considered asset returns
normally distributed. However, nowadays this hypothesis is known as unrealistic but still in
use through widely used models and indicators based on it. For example the Sharpe ratio (and
the derived indicators like the Roy Safety ratio, etc., only works for normally distributed (or at
least symmetric distributions). Here we have a limited but real skewness and a high kurtosis
(ranging from around 4 for the full equity portfolio to more than 7 for the others). With such
returns we can consider the Sharpe ratio biased: that is why we have introduced the Stutzer
index and the Leland alpha.
The other observations we can do based on these usual indicators are mentioned
here following:

The CAGR of the full equity portfolio is the highest and the bonds have
a more limited return. This result is not surprising when we consider
the potential risks of each investment position. The mixed portfolio has
presented a return in the resulting range (which is normal as the
portfolio is a mix of the two)

The same observations can be done for the annualized standard

deviations

The interesting result here is the outperformance of the mixed portfolio

in terms of risk-adjusted return perfectly illustrating the diversification
gain! Indeed the Sharpe ratio of the mixed portfolio illustrates a
maximized return per each unit of risk carried by the investor

44

Step 2: The impact of an exposure to the VIX

First we have determined and analysed the benchmark portfolios. We can now
simulate the impact of an exposure to the VIX. For this purpose we have constructed two new
portfolios:

Equity + VIX portfolio: we have invested 90% of the portfolio nominal

in the total return SPX and 10% on the S&P VIX Medium Term Future
Index. This allows getting an equity-diversified portfolio

Mixed + VIX portfolio: with 64% invested in equity, 46% in bonds and
the remaining 10% in the S&P VIX Medium Term Future Index. This
portfolio allows us to measure the impact of introducing VIX exposure
in a classically diversified portfolio

Exhibit 13: Classic vs. VIX exposed portfolios, returns and distributions

Por$olios(performance(

1000000#

1/
3/
06
#
1/
3/
07
#
1/
3/
08
#
1/
3/
09
#
1/
3/
10
#
1/
3/
11
#
1/
3/
12
#

600000#

Mix#+#VIX#

Mix#

Full#Equity#

Full#Bonds#

0.25%
0.2%
0.15%
0.1%
0.05%
0%
!0.05%

Equity#+#VIX#

Portfolios)modelling)/)Distribution)analysis
Mix$+$VIX
Mix
Equity$+$VIX
Return
0.02%
0.02%
0.02%
St.dev
0.57%
0.79%
1.15%
CAGR
4.98%
5.56%
6.14%
St.dev$p.a
9.01%
12.54%
18.28%
Kurtosis
$$$$$$$$$10.41 $$$$$$$$$$$7.10 $$$$$$$$$$$5.17
Skewness
$$$$$$$$$$$3.25 $$$$$$$$$$$2.74 $$$$$$$$$$$2.38
Sharpe$ratio
$$$$$$$$$$$0.51 $$$$$$$$$$$0.41 $$$$$$$$$$$0.32

!5.4%%
!4.7%%
!4.0%%
!3.3%%
!2.6%%
!1.9%%
!1.2%%
!0.5%%
0.2%%
0.9%%
1.6%%
2.3%%
3.0%%
3.7%%
4.4%%
5.1%%

1400000#

Returns')distribu-on)

Mix%+%VIX%

Mix%

Equity%+%VIX%

Full%equity%

Full%bonds%

Full$Equity
0.03%
1.48%
7.11%
23.51%
$$$$$$$$$$$3.68
$$$$$$$$$$$2.07
$$$$$$$$$$$0.29

Full$Bonds
0.02%
0.65%
4.62%
10.36%
$$$$$$$$$$$6.95
$$$$$$$$$$$2.65
$$$$$$$$$$$0.41 (9)

Note: The exhibit returns the following ranking (based on the Sharpe ratio and skew): 1st: Mix+Vix,
2nd: Mix, 3rd: Full Bonds, 4th: Equity VIX and 5th: Full Equity

9 The risk-free rate is the average 3 months US Treasuries rate over the period.

45

Please note that the same observations about the sample can be applied here as we
have made a work of data harmonisation previous to the analysis and portfolio simulations.
Regarding the rebalancing dates, the same work has been performed for this data
series on the two new portfolios: they both present rebalancing, the first between the equity
and the VIX and the second between the equity, the bonds and the VIX. The maximum
reached for the former portfolio is USD18,749 on August, 15th 2011 (at the date this amount
represented 1.6% of the nominal value, less than the accrued risk-free rate) and for the latter
portfolio the spread reach USD36,573 (at the date 3% of the nominal portfolio but decreasing
to 2% at the end of the sample) on the same day.
The analysis of the returns distribution obviously lead us to the same conclusions
about the non-normality of the distributions than for the classic portfolios but we can also add
some interesting observations:

The VIX participate to increase significantly both the kurtosis (from 3.6
to 5.2 for the equity portfolio and 6.9 to 10 for the mixed portfolio) and
the skew (respectively from 2 to 2.4 and from 2.7 to 3.2) of the
distributions. These observations are a positive perspective for the 3rd
hypothesis of this study. Indeed the more skewness and kurtosis we
have, the less we are exposed to black-swans. Indeed, if we have high
kurtosis it statistically means that most of the returns are around the
average and the positive skew means that most of the remaining returns
are at the right of the mean. This observation can be made between the
two benchmark and the VIX exposed portfolios

The impact of the VIX on the standard deviation of the portfolio

astonishing: the mixed portfolio presents a lower standard deviation
than the portfolio fully invested in bonds! Which historically is a
defensive portfolio.

Regarding the Sharpe it is interesting to see, again, how well the

diversification works. Actually we have surprisingly a better Sharpe
ratio for the bonds than for the equity. The diversification allows
getting the better risk-adjusted return regardless of the best performing
asset class. Moreover if the bonds present a better Sharpe ratio than the
equity, the CAGR over the period still limited and probably not enough
for a portfolio manager

46

Step 3: The impact of using risk-adjusted returns robust to non-normal distributions

At this point of the study we have five portfolios: three with classical constructions
and two with the same base but with a 10% exposure to the VIX on top. The goal of this
research paper is to determine if a portfolio manager should invest in a long VIX instruments
position or not, so we now have to rank our portfolios in order to determine the best
investment strategy. Previously we have seen that classical indicators have returned the
following ranking (based on the Sharpe ratio):

1st: Mix+VIX, 2nd: Mix, 3rd: Full Bonds, 4th: Equity VIX and 5th: Full
Equity

The question is to know if the indicators robust to non-normal

distributions presented in Risk adjusted return: Sharpe ratio
and some others return the same ranking as we have seen that
the assets and portfolios distributions are not normal

If the normal distribution of the returns is very comfortable for modelling purposes, as
mentioned earlier the goal of a portfolio manager is to maximize the return (by increasing the
average of the distribution) reduce the risk (by reducing the area of the distribution bellow 0,
the risk surface). Then the measures of risk-adjusted returns are supposed to allow a ranking
between the strategies. The Sharpe ratio is one of them but we know that it is based on the

normal distributions and needs symmetry around the mean to be accurate (because it is based
on the standard deviation and it penalizes in the same way a bad or a good deviation to
the mean).
Exhibit 14: Sharpe vs. Leland and Stutzer
Portfolios)modelling)/)Distribution)analysis
Mix$+$VIX
Mix
Equity$+$VIX
Sharpe$ratio
$$$$$$$$$$$0.51 $$$$$$$$$$$0.41 $$$$$$$$$$$0.32
Leland$Beta
$$$$$$$$$$$0.35 $$$$$$$$$$$0.52 $$$$$$$$$$$0.77
Leland$Alpha
$$$$$$$$$0.022 $$$$$$$$$0.017 $$$$$$$$$0.006
Stutzer$to$Rf
4.12%
1.96%
2.58%
Stutzer$to$Bonds
0.29%
0.00%
0.30%

Full$Equity
$$$$$$$$$$$0.29
n.a
n.a
1.38%
0.10%

Full$Bonds
$$$$$$$$$$$0.41
n.a
n.a
2.43%
n.a
(10)

Note: Indicators return different rankings but the Mix+VIX is always the better risk-adjusted
investment


10 The market price of risk based on Leland model was calculted considering the SPXTR

as the market and the average 3M Treasury over the period as risk free rate. The result
was b=1.45.

47

The exhibit 14 confirms the outperformance of the better-diversified portfolio: the

Mix+VIX. This result confirms the importance of a good asset allocation and diversification.
Another interesting point for us is the risk-adjusted outperformance of the Equity+VIX on the
full equity portfolio. However the remaining question is to know if the VIX actually is a
better diversifier than the bonds because the indicators are discordant on the subject.
Then the remaining question is between the Equity+VIX and the Mix. At this point
we have two arguments to consider:

Stutzer comments the first argument in his paper (Stutzer, 2000), his
work is posterior to Lelands and he comments on the strength of his
indicator. Lelands indicator accuracy is based on the relationship
between the passive portfolio expected return (the market) and the
models measure of risk. In other words, to a certain level risk is
assigned a required performance level, but for example Leland did not
try to explain the level of risk free rate. The market and risk free rates
are inputs in Lelands model but how can we be sure of the values?

The strength of the Stutzer index is to do not consider this kind of

inputs, the goal of the Stutzer index is to measure the ability of a
portfolio to outperform another (cf. Risk adjusted return: Sharpe ratio
and some others). So we can clearly here use a Stutzer between the Mix
and the Equity+VIX to determine which one tends to outperform the
other: the result is: Equity+VIX clearly outperform the Mix portfolio.

As a conclusion we can affirm that the VIX is the better diversifier tested here.
Moreover another point has not been considered here but should be of interest to finance
professionals: if the VIX with only 10% of the portfolio diversify better than the bonds, then
it allows the portfolio manager to free more nominal for the active management than the
historical diversifier: the bonds. Then we cannot reject this second hypothesis and it drives
us to our third hypothesis: can we use selectively the volatility to protect a portfolio in case of
a Black-Swan?

48

Hypothesis 3: Volatility protects from Black-Swans

Hypothesis origin

We have seen previously that volatility is an efficient diversifier and this

diversification effect allowed us to reduce significantly the risk-adjusted return of a portfolio
exposed to the US market. Indeed, by adding 10% of VIX to portfolios exposed to US
equities and bonds we have improved returns distributions, Sharpe ratios, Leland Alpha and
Stutzer Index. Moreover we have proved that 10% of VIX diversify more 90% of equity
exposure than 40% of bonds do with 60% of equity (at least we have proved that the riskadjusted of the former configuration is higher).
What we need to know at this stage is if the VIX action is through a continuous
positive participation to the portfolio return and standard deviation (if it is the case then a
permanent exposure is necessary to benefit from the VIX exposure) or if it acts as a downside
floor (allowing to benefit from it with punctual exposure). What we have seen drives us to
assume that the 2nd action describes better the VIX exposure impact on the portfolio, indeed:

The more the SPX is bear, the more the VIX will pike

The VIX exposure has increased the skew and the kurtosis of the return
distribution. It means that we are limiting our important losses and the
population of returns around the mean (close to 0% as we are on a daily
basis)

Nevertheless we also have seen that long VIX exposure presents a negative riskadjusted return; in other words an exposure to the VIX is very expensive! This is even more
true when we have a contango on the VIX futures term structure (which is the normal
situation11). So the question here is double, it is about cost and risk management:

Can we reduce the price of the VIX exposure by using a punctual and
conditional exposure system?

Does this dynamic exposure do the work when it comes to protect a

portfolio from a market downturn (and in particular important market
downturns, Black-Swans) with a punctual exposure to the VIX?

11 Please refer to the BNP Paribas VIX Handbook, (BNP

Paribas, 2010)
49

Demonstration of the hypothesis

Presentation of our conditional VIX exposure mechanism:

In order to test our hypothesis we have defined a simple conditional VIX exposure
mechanism. Firstly, please note that this hypothesis is in line with the previous work.
Consequently we have changed neither the assets (SPXTR, VIX MT Future, 10Y US Bonds),
analysed period nor the monthly rebalancing mechanism. The conditional VIX exposure
mechanism has been plugged to the previous models.
Here we have decided to monitor the 5-Business Days moving average (of the spot
VIX (to get instantaneous information, the risk as estimated by the market) and continuously
compare the distance of the spot VIX to this 5-Business Days average: if the spot VIX exceed
the moving average by more than a given proportion (we do not give any figure here as this
parameter is optimized for each portfolio), we rebalance the portfolio to get an exposure to the
VIX Mid-Term Futures. Meanwhile the condition is verified, we maintain the exposure to the
VIX without rebalancing. When the condition is not verified anymore, then we rebalance the
portfolio again to return to the targeted asset weight.
Please note that what we call rebalancing the portfolio here means simulating buys
and sells of the present portfolio in order to restore the targeted weight of each asset in the
portfolio. With the conditional exposure to the VIX the rebalancing is more complex than for
the previous models, here we have two potential weights, the classic portfolio or this portfolio
with a VIX exposure. Because we have not allowed our portfolio manager to borrow the VIX
position (it would create a gearing in the portfolio and bias our analysis), in this case we have
to reduce the weight of the classic portfolio to free the required amount destined to buy the
VIX position.
For example, for the mixed portfolio if after couple of weeks the equities have
outperformed the bonds, then the weight of the equities will be higher than the initial one (e.g.
65% of the portfolio and the bonds worth 35% of the portfolio now). Then the VIX is very
high and our strategy suggest buying it. Then the rebalancing of the portfolio will be to sell
11pp of our equity position, buy 1pp of bonds and 10pp of VIX (the conditional weight of the
VIX we have chose). In addition we have decided to do not rebalance every day when the
condition is verified but only when we exit the position.

50

Optimisation of the mechanism for the full equity portfolio:

The first parameter we had to define was the moving average. The choice of the 5Business day is the result of some tests. The idea was to do not be too sensitive to reduced
market moves (because we have not integrated the transaction costs here but in real life a
portfolio manager has to pay them) but also not miss any micro-crash with important
costs in terms of returns. Actually the philosophy here is fully based on what the volatility
skew lesson, the "crash-o-phobia12: when losses come they come faster and stronger than the
gains.
The second parameter we worked on is the distance between the spot VIX and the
VIX 5-Business day moving average to trigger or stop the exposure to VIX Mid-Term Future
Index. When we have implemented the model we have found a high sensitivity of the global
portfolio return to this parameter. Thus we have decided to really investigate this relation and
optimize this parameter in order to move closer to reality (we have no doubt that a portfolio
manager would do the same thing). For this optimisation we have implemented sensitivities
table with a 1pp tick and we have tested all the distances between 0 and 100% (in a linear
basis). Our results are presented in the following graphic. Then we have decided to choose the
best performing value for the rest of the study.
Exhibit 15: Distance to the moving average optimization for the full equity portfolio

Por$olio'sensi+vity'to'VIX'
exposure'
4000000"
3000000"
2000000"
1000000"
0"
0%" 10%"20%" 30%" 40%" 50%"60%" 70%" 80%" 90%"100%"
Por0olio"FV"

12 The concept is presented in (Rubinstein,

1994) to explain the end of the volatility smile in

favor of the volatility skew.

51

The exhibit 15 presents the relation between the final portfolio values of the portfolio
and the sensitivity of the mechanism to the VIX volatility. We can observe a clear pike at
11%. We can also observe that the extreme values are close to the reference portfolios: for a
0% distance we are close to the Equity and permanent VIX exposure performance because we
are almost every time VIX exposed. It is interesting to observe that we are underperforming
here the original portfolio due to the more frequent rebalancing (when we rebalance we sell
the performing assets and buy the bear ones; if it is done too frequently then we break the
compounding effect on the bull assets). The other extreme (100%) is exactly the performance
of the VIXTR because we never activate the VIX exposure.
Optimisation of the mechanism for the mixed portfolio:
The same optimization work has been performed for the mixed portfolio. Regarding
the moving average for comparability reasons and because this is more related to the VIX
than the other assets composing the portfolio, we have decided to do not change the 5Business day moving average.
Regarding the parameter relating the portfolio performance to the VIX exposure, we
have performed the same sensitivity analysis. We were aware that the results should be
similar because what this parameter do is optimising our exposure to the VIX Mid-Term
future Index but we did not know how the portfolio will react to this new rebalancing
movements. For this second portfolio we have decided to use the same parameter to trigger
our exposure to VIX: 11%.
Exhibit 16: Distance to the moving average optimization for the mixed portfolio

Por$olio'sensi+vity'to'VIX'
exposure'
2000000"
1500000"
1000000"
500000"
0"
0%" 10%"20%" 30%" 40%" 50%"60%" 70%" 80%" 90%"100%"
Por0olio"FV"

Note: As expected the optimized parameter value is the same, however we can see that the shape of the
result line is different.

52

Impact on the portfolio returns and distributions:

Above all we would like to say that at this point the results were quiet unexpected to
us. Indeed at this point the attentive lector has probably noticed the relatively similar shape of
the two sensitivity curves but also the significant differences of the scales. Where we had a
little more than 1pp between the Mix+VIX and Equity+VIX portfolios CAGR (in favour of
the Equity+VIX portfolio), after applying our dynamic exposure mechanism, the
equity+Dynamic VIX have outperformed the mixed portfolio by 12pp of CAGR!
Exhibit 17: Constant vs. dynamic exposure performance

Por$olios(performance(

Returns')distribu-on)
0.2"

3000000#
2500000#
2000000#
1500000#
1000000#
500000#

0.15"
0.1"
0"

'5.5%"
'4.9%"
'4.3%"
'3.7%"
'3.1%"
'2.5%"
'1.9%"
'1.3%"
'0.7%"
'0.1%"
0.5%"
1.1%"
1.7%"
2.3%"
2.9%"
3.5%"
4.1%"
4.7%"
5.3%"

1/
10
/0
6#
1/
10
/0
7#
1/
10
/0
8#
1/
10
/0
9#
1/
10
/1
0#
1/
10
/1
1#
1/
10
/1
2#

0.05"

Mix#+#dyn#VIX#

Equity#+#dyn#VIX#

Mix"+"dyn"VIX"

Equity"+"dyn"VIX"

Mix#+#VIX#

Equity#+#VIX#

Mix"+"VIX"

Equity"+"VIX"

Portfolios)modelling)/)Distribution)analysis
Mix$+$dyn$VIX Equity$+$dyn$VIX
Mix$+$VIX
Equity$+$VIX
Return
0.03%
0.07%
0.02%
0.02%
St.dev
0.85%
1.22%
0.57%
1.15%
CAGR
7.87%
20.34%
4.98%
6.14%
St.dev$p.a
13.47%
19.42%
9.01%
18.28%
Kurtosis
$$$$$$$$$$$$$$$$$$ 28.99 $$$$$$$$$$$$$$$$$$ 38.20 $$$$$$$$$$$$$$$$$$$$9.13 $$$$$$$$$$$$$$$$$$$$4.41
Skewness
$$$$$$$$$$$$$$$$$$$$4.76 $$$$$$$$$$$$$$$$$$$$5.35 $$$$$$$$$$$$$$$$$$$$3.08 $$$$$$$$$$$$$$$$$$$$2.25
Sharpe$ratio
$$$$$$$$$$$$$$$$$$$$0.58 $$$$$$$$$$$$$$$$$$$$1.05 $$$$$$$$$$$$$$$$$$$$0.55 $$$$$$$$$$$$$$$$$$$$0.34
Note: The exhibit returns the following ranking (based on the Sharpe ratio): 1st Equity+dyn VIX, 2nd
Mix+dyn VIX, 3rd Mix+constant VIX and 4th Equity+constant VIX

We have performed on the new portfolios the same analysis than for the previous
ones. The exhibit 17 resumes our results. The key points of interests are:

We naturally have lost part of the diversification effect (when

the portfolio is not VIX exposed it moves like the reference
market), which explain the higher standard deviation for the two
dynamically exposed portfolios. At this point we can only agree
with the idea that the VIX is not an equity hedge but an equity
diversifier.

53

Regarding the returns we are not surprised that the enhanced

VIX exposure mechanism allow to deliver higher returns, as
mentioned earlier the long VIX position is expensive and it was
a goal of the strategy to reduce this cost and improve the return

At this point we do not know anything about the risk-adjusted

return because both the risk and the return have increased.
However the analysis of the distribution is very interesting on
the purpose. The mechanism has allowed an extraordinary
increase of the kurtosis: x3 for the mixed portfolio and x10 for
the pure equity!

The impact of the new mechanism on the Sharpe ratio is

interesting, for the mixed portfolio it looks like the improvement
was very limited (from 0.55 to 0.58). The impact is higher for
the Equity+Dynamic VIX driven by the significant increase of
the return.

Exhibit 18: Constant vs. dynamic exposure to VIX, impact on risk-adjusted returns
Portfolios)modelling)/)Distribution)analysis
Mix$+$dyn$VIX Equity$+$dyn$VIX
Mix$+$VIX
Equity$+$VIX
Sharpe$ratio
$$$$$$$$$$$$$$$$$$$$0.58 $$$$$$$$$$$$$$$$$$$$1.05 $$$$$$$$$$$$$$$$$$$$0.55 $$$$$$$$$$$$$$$$$$$$0.34
Leland$Beta
$$$$$$$$$$$$$$$$$$$$0.09 $$$$$$$$$$$$$$$$$$$$0.27 $$$$$$$$$$$$$$$$$$$$0.33 $$$$$$$$$$$$$$$$$$$$0.72
Leland$Alpha
$$$$$$$$$$$$$$$$$$ 0.073 $$$$$$$$$$$$$$$$$$ 0.184 $$$$$$$$$$$$$$$$$$ 0.026 $$$$$$$$$$$$$$$$$$ 0.010
Stutzer$to$Rf
10.23%
15.19%
4.12%
2.58%
Stutzer$to$Bonds
7.23%
15.61%
0.29%
0.30%

(13)

Note: If the Leland and Stutzer indicators does not change the ranking they clearly shows the
superiority of the dynamic exposure mechanism

The distributions of the portfolios are clearly not normal (especially the distributions
of the new portfolios) so we have applied them the risk-adjusted measures robust to nonnormality. If the indicators does not change the ranking here, it clearly demonstrate the
superiority of the new strategy. As a consequence we cannot reject this third and last
hypothesis.

13 The calculation of the market price of risk necessary for the calculation of the Leland

Beta has not change, as we have not changed our benchmark. The result is b=1.45.

54

Our conclusions
Our goal with this research paper was to give an insight of what the volatility is and
the real impact it can have on a portfolio. If we faced real limitations during our research (lack
of access to market information, the technical aspect of the subject leading most of the papers
about volatility to be destined to quants people, limits in coding for the modelling), we are
satisfied by our results.
First we have tried to define a framework to define what an asset class really is
because we have found that on the subject, very few people rationalize them choice. We are
aware that this question is purely academic in contradiction with our mind-set of writing a
paper destined to financial markets professionals but as our research has been done in an
academic context we consider that the hypothesis has a legitimate place in this study.
Furthermore we have tried to apply this practical philosophy to our demonstration using the
market reality as a central criterion.
Our second hypothesis was the entry point to the quantitative aspect of our paper. We
have attempted to find an answer to the asset recorrelation problem of portfolio managers.
Indeed the recent financial crisis has highlighted the limits of the normality and the
superiority of the chaos: the victory of Mandelbrot on Sharpe. In parallel, progress in
derivatives products and finance industry in general has open a world of new asset classes:
hidden asset classes. Based on volatility, one of them, we have successfully increased the
risk-adjusted return of different portfolios and we have submitted our resulting portfolio to an
analysis with indicators robust to non-normal returns.
To finish, we have tried to enhance our results by implementing a tool reducing the
cost of this powerful diversifier. When most of the studies have stopped the analysis by
highlighting the cost of an exposure to volatility instruments, we have described and tested an
efficient way to boost them effect without leveraging our portfolio: by reducing the cost using
it parsimoniously. If the VIX (our proxy for the implied volatility in general) is not investable
via the spot, the spot is a powerful indicator of danger zone thanks to its negative inner
delta and future oriented properties (it is derived from options). We have used it to define our
investment strategy on VIX futures. This has allowed us to pass from a 6 to 20% CAGR for
the same portfolio. Who today can afford not earning 13% extra yield yearly? The next
improvement could be to try to find a way to use a varying gearing for the exposure to the
VIX!

55

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