Financial regulations such as the Dodd-Frank Act and Volcker Rule were constructed to keep large banks from straying from their core lines of business. As these rules have been incrementally implemented over the past five years or so, realized volatility has only spiked above 20 twice.
Market expectations for volatility seemingly overestimated the frequency that these elevated levels would occur. We can explore the numbers during this period of increased regulation to compare market expectations vs. realized volatility.
Using the S&P 500 as a proxy, for the five year period ending 7/31/2017, we see the one month expected volatility (white – 1 month implied volatility) on average was over 1% higher than what the volatility ended up being (green – lagged one month realized volatility).
We get even more drastic results when inspecting this concept using the VIX index. Exposure to movements in the VIX index is possible via derivatives or by regulated products that utilize them. Figure 2 shows the relationship between the settlement price of VIX and lagged generic 1 & 3-month VIX futures.
The average 3-month futures closing price was 309 bps higher than the level in which the future settled during this period. For the five year period ending in July 2017, a short futures position in VIX entered three months before expiration, settled on average 16.9% (18.23 vs. 15.14) lower than entry1. The average futures price 1-month before settlement was 95 bps 1 higher than at settlement. A short position in 1-month contracts over this period settled at an average value of 5.9% (16.1 vs. 15.14) lower than entry1. Rolling 1-month contracts could be repeated 3 times as often as 3-month contracts leading to 3 times the average value difference2. During this period, the shorter-duration strategy (5.9% *3 = 17.7%) hypothetically would have seen more of a valuation change than shorting 3-month contracts on average.
Now that weekly VIX settlement contracts are available, rolling even shorter duration futures can be examined. Running the same analysis as before, but examining VIX futures one week before settlement, Figure 3 shows an average value drop of 3.5% per trade (for only one week!).
Continuously rolling the average change in value for 1-week contracts comes to over 42% 2 per three-month period on average.
