Suppose you hold an ETF on the S&P 500 index. You want to use the VIX to hedge y
ID: 2765372 • Letter: S
Question
Suppose you hold an ETF on the S&P 500 index. You want to use the VIX to hedge your position. Can we empirically delta hedge the S&P 500 position with the VIX? Why or why not? Calculate and report the delta and the average returns to the hedged and un-hedged position. Measure and report the volatilities of each position. Measure and report the largest 3 monthly losses of the unhedged position. What are the losses of the hedged position in these three months? How do you interpret your results in terms of the effectiveness of hedging with the VIX?Explanation / Answer
The introduction of VIX futures has been a major financial innovation that will facilitate to a great extent the hedging of volatility risk. Using spot VIX, VIX futures, S&P 500 futures, S&P 500 options and S&P 500 futures options, this study examines alternate models within a delta-vega neutral strategy. VIX futures are found to outperform vanilla options in hedging a short position on S&P 500 futures call options. In particular, while incorporating stochastic volatility on average outperforms in out-of-sample hedging, adding price jumps further enhances the hedging performance for short-term options during the post-crash-relaxation period.
VIX futures and options are important for practices since VIX is implied volatility of the S&P 500 Index (SPX), the most widely followed index of large-cap U.S. stocks and considered as an indicator for the U.S. economy. Many mutual funds, index funds2 and exchange-traded funds (ETF) attempt to replicate the performance of the SPX by holding the same stocks in the same proportions as the index. In recent years, ETFs and index funds have become the most popular investment products worldwide and the need for hedging price risk and volatility risk of the index-related investment vehicles has become urgent, particularly during periods of extreme market movements.
There is also a hedge need for financial intermediaries such as option market-makers and hedge funds who provide liquidity to end-users by taking the other side of the end-user net demand. In reality, however, even market-makers cannot hedge options perfectly because of the impossibility of trading continuously, stochastic volatility, jumps in the underlying and transaction costs (Gârleanu, Pedersen and Poteshman, 2009). In light of these facts, this study considers how options are hedged using VIX futures by competitive risk-averse market-makers who face stochastic volatility and jumps. The risks of an option writer can be partitioned into price risk and volatility risk. Carr and Madan (1998) suggest options on a straddle and Brenner et al. (2006) construct a straddle to hedge volatility risk.
The introduction of VIX futures and options has been a major financial innovation that facilitates to a great extent the hedging of volatility risk. Since VIX futures and options settle to the implied volatility of the S&P 500, they are effective to cross-hedge the vega risk of stock options and stock indexes correlated to the S&P 500, whether these are exchange-traded or embedded in other assets. The hedging effectiveness of the new VIX derivatives is an important issue that has not yet been concluded in the literature.
Standard & Poor’s
The high volatility of the Australian dollar in recent years has resulted in currency gains and losses impacting on investment portfolio returns. As a result, many now question how to manage global equities’ currency exposure and whether to employ a fully hedged, partially hedged or unhedged position in portfolios.
Pending a client’s risk and return objectives, S&P typically suggests a currency unhedged global equities position for accumulators’ portfolios and a combination of hedged, unhedged and actively managed exposure for income stream recipients.
For accumulators making regular contributions, the impact of the volatile Australian dollar on investor returns is negligible over the long run.
It also has a high correlation to global growth and hence when growth declines (as in recent months), equities and the Australian dollar typically fall in value, but an unhedged position provides a buffer due to gains from the Australian dollar depreciation.
In addition, the earnings of Australian companies are impacted significantly by the value of the Australian dollar, and diversification benefits are typically achieved by diversifying a portfolio’s exposure to any one currency. Hence for the long-term accumulator portfolio, S&P typically suggests a currency unhedged global equities exposure.
However, the risks change for portfolios where contributions are no longer being made. Income stream recipients, for example, are in the phase of their lives where they are employing the reverse of dollar cost averaging (selling units regularly for income payments) and can be significantly impacted by the volatile Australian dollar.
During the 2000s, investors faced low returns from global equities which were compounded for unhedged portfolios due to the long-term upward trend in the Australian dollar, with the end result that unhedged portfolios not only endured poor returns from underlying assets, but also experienced losses from unhedged Australian dollar exposures as the Australian dollar rose, benefiting from the huge growth in demand for resources from 2003 onwards.
Hence, for investors no longer contributing to portfolios, we suggest considering 50 per cent unhedged, 25 per cent hedged and 25 per cent actively managed.
Back testing analysis shows the optimal currency hedging position over the last 20 years would have been 40 per cent hedged and 60 per cent unhedged – and hence, it makes sense to have a combination of hedged and unhedged global equities exposure in a portfolio.
Also, not only have hedging strategies protected investors when the Australian dollar is on a long-term upward trend, but have also aided returns in recent years due to Australian investors being paid to hedge portfolios (ie the carry trade).
Using active currency management in a portfolio can significantly reduce the impact of Australian dollar volatility on portfolio returns by balancing the exposure to hedged and unhedged global equities, pending the Australian dollar valuation.
However, in practice, this approach is extremely difficult to manage and is usually outsourced to a fund with separate currency management expertise.
Ultimately, there is no optimal hedging strategy for all investors as risk and return objectives plus stage-of-life will impact on which strategy is most appropriate to employ.
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