Understanding The Difference Between Volatility Risk Premium And VIX Futures Premium

Following a recent RIA Channel Webinar we presented with VelocityShares, we received a series of questions that reminded us of the many facets of volatility trading that people feel far from comfortable with. Beyond the simpler questions, like whether or not the VIX is an investable index (it is of course not), there seemed to be a general misunderstanding of where the returns in popular VIX linked Exchange Traded Products (ETPs) like SVXY and ZIV come from. This misunderstanding seems to stem from a confusion of terms like contango, roll yield, Volatility Risk Premium (VRP), and Futures Risk Premium (FRP). This article will try and explain the source of these returns by more clearly describing the difference between VRP and FRP.

In a characteristically well-written article, Vance Harwood has already approached a related misunderstanding before, and I recommend reading his article ‘The Cost of Contango: Not the Daily Roll’ to help better understand how the shape of the VIX futures term structure effects the price of popular ETPs. He explains how these products ‘roll futures’, and that this roll does not affect their returns, but instead their returns frequently arise from the inevitable changes in value of the VIX futures themselves – a change in value that could be better described as ‘contango decay’ than ‘roll yield’.

‘Contango decay’ can be thought of as the steady decline of VIX futures prices towards the value of the VIX Index - or as some would argue – the pull of the VIX Index towards the VIX futures. I won’t go into the arguments for and against either interpretation, but suffice it to say the first argument relies on the relationship between traditional investable commodities and their futures and ignores the ‘uninvestability’ of the VIX Index, while the latter relies on the Vega weights of the portfolio of options that the VIX Index references compared with the portfolio that the futures reference. It’s important to remember that the VIX Index has the only futures underlying that is totally uninvestable and this facet alone gives the behavior of its futures some surprising characteristics.

So what is this contango decay and is it the same as VRP? Well simply put, no! Contango decay is a characteristic of futures prices while VRP is a characteristic of options markets – including options on the S&P 500. It’s perhaps helpful to think how there’s contango decay in oil futures that no one would ever describe as VRP. The confusion of these two terms can cause investors to make poor decisions when investing in VIX ETPs, and properly understanding the difference can help investors better utilize these products.

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