Two New Exotic Products from the CBOE

The CBOE has begun the offering process on two new and highly innovative volatility-related products that could have broad implications for the exchange traded products market and index investing in general.

The new S&P 500 Variance Futures are futures contracts on the realized variance of the S&P 500 index. This is in contrast with VIX futures, which trade on the impliedvolatility of the S&P 500; however, according to a CBOE press release, the ability to combine the two may have motivated their creation:

The S&P 500 Variance futures contract, like over-the-counter (OTC) variance swaps, allows users to trade the difference between the implied and realized variance of the S&P 500 Index. CFE's futures contract will offer the same quoting conventions and economic performance of OTC variance swaps, while providing the advantages of exchange-traded contracts -- transparency, price discovery and counterparty clearing guarantees.

Implied volatility, such as that calculated by the VIX index, measures forward-looking expectations for the movement of an index or asset price (is the volatility 'implied' by options prices). Realized variance, however, is the degree actual fluctuations in an asset's value as they have occurred over a period of time. The difference, often referred to as 'volatility arbitrage', has been of interest to investors and practitioners and has been calculated by the CBOE index VTY. The payout formula for the new variance futures is enormously complex, but may serve as a useful technical indicator for sophisticated market analysts.

The other new product, SPX Variance Strips(nicknamed 'V-Strips', ticker VSTRP), is even more complicated, but may have an enormous impact on equity investing. Very briefly, V-Strips allow investors to trade "a large and complex portfolio of SPX options in a single transaction"--namely, the portfolio of options that make up the VIX index. In fact, V-Strips are "intended to replicate S&P 500 implied variance exposure."

The reason why this product is so significant is that until recently, the only way to obtain exposure to implied volatility was through VIX futures contracts or exchange-traded products that track VIX futures portfolios. These products have seen numerous problems, but have become popular because many investors either want to bet on the 'fear gauge' properties of the VIX or because the VIX may serve as a hedge on the S&P 500 itself(see our two research papers on the subject). If V-Strips in fact allow direct trading on the VIX portfolio itself, traders may be able to use them to hedge equity exposure in a way that other volatility products have failed to achieve.

It is clear that these products are extremely complicated, and their underlying assets would not typically be suitable for retail investors. In fact, the CBOE very explicitly describes both of these products as designed for "qualified professionals," namely over-the-counter (OTC) customers who may benefit from an open and transparent market. However, if the market for these products takes off, we can expect exchange-traded notes or funds linked to these futures contracts spring up quickly, just as we have seen a proliferation of ETNs and ETFs on VIX futures. In that case, these incredibly technical innovations may find their way into the portfolios of unsophisticated retail investors.