The new market for volatility trading

Abstract

This study analyses the new market for trading volatility; VIX futures. We first use market data to establish the relationship between VIX futures prices and the index itself. We observe that VIX futures and VIX are highly correlated; the term structure of average VIX futures prices is upward sloping, whereas the term structure of VIX futures volatility is downward sloping. To establish a theoretical relationship between VIX futures and VIX, we model the instantaneous variance using a simple square root mean-reverting process with a stochastic long-term mean level. Using daily calibrated long-term mean and VIX, the model gives good predictions of VIX futures prices under normal market situation. These parameter estimates could be used to price VIX options. © 2010 Wiley Periodicals, Inc.