Understanding volatility term structure
Although volatility term structure (based on recent research from “Asset Pricing Implications of Volatility Term Structure Risk”) may still be a new concept to many, it offers insights and potentially, profitable meanings. The market volatility term structure can help predict the economic state of a market as well as shed light on constructing profitable strategies.
What is volatility term structure and why is it important?
When talking about volatility, people often relate to “realized volatility” and “implied volatility.” The former is calculated from return data, which reflects more of the past and current status, whereas the latter is calculated from options data, which reflects more on the investor’s expectations for the future.
It is usually the case that the stock return is negatively correlated with realized volatility, and the future stock return is positively correlated with implied volatility.
The CBOE Volatility Index (VIX) is an important measure for market volatility. The VIX shows 30-day implied volatility based on S&P 500 index option prices. It is always used as a proxy for the systematic risk of the market (see “VIX term structure,” below).
The “VIX term structure” offers a new way of looking at information from S&P 500 options. The term structure of the VIX index is the VIX plotted on different expirations.
It suggests the market’s expectation on the future volatility. Since volatility is a measure of systematic risk, the VIX term structure suggests the trend of future market risk. If the VIX is upward-sloping, it implies that investors expect to see the volatility (risk) of the market going up in the future.
If the VIX is downward sloping, it indicates that investors expect to see the volatility of the market going down in the future.
Based on the above assertions, the data in “VIX term structure,” acquired from the CBOE, suggests that on July 9, 2014, the market expects the volatility to rise in the next10 months.
“Breaking it down,” (below) shows the implied volatility term structure of individual equities Tesla and Netflix on July 24, 2013. The implied volatility term structures for those two stocks are calculated as the at-the-money implied volatilities on 30- to 720-days expiration from the volatility surface dataset of OptionMetrics.
Clearly, the volatility term structure of offers more information than the current volatility alone, because it includes the current level of implied volatility and the trend of the future implied volatility.
This article will focus on the implications of the market volatility term structure (VIX term structure), as opposed to the individual stock’s implied volatility. Based on empirical research on VIX term structure, the most important factor from the VIX term structure is its “slope.” What does the VIX slope reveal?