Next Level in Risk Management? Hedging and Trading Strategies of Volatility Derivatives Using VIX Futures

Abstract

The paper analyses how volatility derivatives on the volatility index VIX can be used as trading and risk management tools for investors and trad-ers. Volatility and the different types of volatility are discussed. It elabo-rates upon assumptions of option pricing models and specifies which complications accompany the determination of volatility. The weaknesses of the Black-Scholes-Merton model are illuminated and the difference between the model assumptions regarding volatility and market reality is identified. Using the skew- and term-curve-effect, the paper demonstrates how volatility behaves in reality towards other model parameters. In terms of pure volatility trading, the volatility derivatives are presented and analysed in terms of their merits and fields of application. Additionally, the stylized facts about volatility are considered. The paper shows how VIX futures and options can hedge equity portfolios and when they are superior to traditional hedging alternatives and compares the outcome of a VIX hedging strategy with a Buy & Hold strategy of the S & P 500 index over a time period of 20 years.