The Puzzling Market for Stock Market Volatility Insurance

Tuck professor Ing-Haw Cheng finds that, contrary to conventional thinking, the premium for insurance has been slow to increase after risk rises—even declining in some cases.

Tuck professor Ing-Haw Cheng finds that, contrary to conventional thinking, the premium for insurance has been slow to increase after risk rises—even declining in some cases.

Stock market volatility has moved from an esoteric number watched by Wall Street options traders to defining the latest hot asset class traded by investors more broadly. Hedge funds and asset management firms ranging from BlackRock, PIMCO, Barclays, and JP Morgan have all published investment insights on how to hedge and speculate using volatility derivatives. But as Tuck assistant professor Ing-Haw Cheng explains in a new working paper, one of the relatively new yet most popular of these markets has anomalies that practitioners might be able to take advantage of—while they last.

First, some background. Stock market volatility measures how far stock prices might move up or down over a month. The Chicago Board Options Exchange (CBOE) Volatility Index, or VIX, has long served as a benchmark number investors watch to gauge the market’s expectations of future volatility. Known as the market’s “fear gauge,” the VIX tends to be high during periods of market stress such as the 2008 financial crisis, and tends to be low during calmer periods.

About 12 years ago, the CBOE launched a derivatives market, the VIX futures market, that trades what investors expect the VIX to be in the future. The VIX future works a little bit like an insurance policy that kicks in when a natural disaster happens. The difference with VIX futures is that the triggering event is not a flood or a hurricane but a rise in market volatility. Hedge funds like to sell this insurance to profit from fears of volatility, while asset managers and other investors often find the product attractive as short-term insurance against market turmoil.

For example, if the VIX today were 13, that would indicate that the S&P 500 may gain or lose somewhere around 13 percent of its current value in the upcoming 30 days. In this case, an asset manager might enter a VIX futures contract that profits if the VIX ends above 16 next month, but requires the manager to pay in (and lose money) if it ends below. In this way, the asset manager is protected against an increase in the VIX above 16. During the 2008 financial crisis, the VIX reached levels above 80.

But this protection comes at a high cost. For every hundred dollars worth of insurance, the buyer ends up, on average, paying three percent of the value of the protection per month. With average annual returns on the S&P 500 at about five percent, this cost is very expensive. In the above example, the VIX tends to end below 16 more often than not, requiring the asset manager to pay in. Typically, hedge funds profit in this case.

Since 2004, the VIX futures market has grown spectacularly to become one of the premier markets where investors trade volatility. Yet Cheng noticed something surprising about these markets: the premiums for protection have historically been slow to increase after risk increases, even declining in some cases.  Take, for example, the 2008 financial crisis, or the approach of the Euro crisis in 2011. Even as various alarm bells rose in markets, warning of trouble ahead, the VIX premium declined before rising. In other words, VIX futures were cheap on the eve of these episodes, not expensive.

This behavior is quite anomalous, as standard models predict that the cost of insurance should rise with risk. “What’s happening is that when the VIX starts going up, those who have purchased the insurance cash out, but they don’t buy more,” Cheng points out in his paper, “The VIX Premium.” “With low demand, the insurance sells cheaply. What this suggests is that asset managers could have bought the insurance at a low cost when they needed it most—when the flood waters were rising.”  From an academic perspective, Cheng points out that this suggests a serious need to revisit theories about why investors trade volatility insurance in the first place.

For practitioners, such as asset managers looking to protect against volatile markets, and hedge funds looking to sell insurance for the least risk, the message of the paper is to recognize that VIX futures are not like regular insurance—pay attention to when to buy and sell.