Hedging Market Tail Risk Factors with Volatility Indices

Abstract

Volatility indices and financial engineering appear as a response to mitigate the damage of extreme events caused by apparent misbehaviors in stock markets. This paper studies the Cboe Volatility Index known as the VIX as well as its related derivatives and the risk management applied with the VIX. From quantitative finance research, we seek to extract how it can be a valuable component as an effective hedging tool in “no downside” investment strategies and as a barometer of market tail risk factors. Results show recent evidence of its “insensitivity” effect relative to the US stock market that could prevent its derivatives from being fair hedges. Time varying correlations and co-movements between the VIX and a proxy of the US stock market show another limitation of VIX hedging. The second analysis here focuses on its ability to be a forward-looking indicator of realized volatility and potential stress in stock markets for financial institutions. Results indicate some predictiveness of the amplitude of future movements if not directional. They also show the VIX ability to indicate the probability of a tail event in the near future. The paper also outlines criticism of the VIX and explains why the Cboe recently introduced the 1-day VIX. The primary outcome of this research is to understand the optimal use of volatility indices for hedging strategies and as tail risk predictor. The main objective of this paper is to verify how effective VIX options are as a hedge against drawdowns in the US stock market.

Keywords: VIX, SPX, volatility indices, hedging, tail risk, implied volatility, historical volatility, options, time varying correlation

JEL Classification: C3, G1