A Perfect Ten? CBOE's Latest Vol Contract Could Be A Stunner

Nov 10, 2014

The CBOE Futures Exchange announced it will launch futures on the CBOE/CBOT 10-year U.S. Treasury Note Volatility Index (ticker symbol: VXTYN) on November 13.  It is calculated by applying the CBOE Volatility Index (VIX) methodology to futures options data from CME Group’s 10-year U.S. Treasury note contract — one of CME’s most actively traded interest rate options products. CBOE calculates and disseminates the VXTYN Index values as part of an agreement between CBOE and CME Group.

JLN’s Sarah Rudolph spoke with John Angelos, director of institutional marketing, U.S. and head of Asia Pacific at the Chicago Board Options Exchange (CBOE) in advance of the launch, to find out more details about the contract’s design, potential users, and what makes it unique.

Q: Tell me about the origins of this futures contract.

A: The VIX has been wildly successful in the equity derivative space, so we wanted to increase our suite of volatility products, and the natural fit is the fixed income space. When you look at the size and scope of the fixed income space and what’s going on with monetary policy, the ending of Quantitative Easing and next potential rate hike, all the talk on Wall Street is about interest rate volatility.

We have partnered with Yoshiki Obayashi, managing director at Applied Academics and an expert in the fixed income space, and brought him on as a consultant to help construct the product. Over the past year and a half we have been running up and down Wall Street talking to buy- and sell- side interest rate practitioners and getting their feedback on constructing the product. We used our VIX methodology and applied it to CME’s option prices on the 10-Year Note futures contracts to create the fixed income VIX. We are extracting the treasury option data points and putting them in to our proprietary VIX methodology to create the VXTYN. The new futures contract will trade on the CBOE Futures Exchange, as do futures on the VIX.

Q: What is the basic difference between the VIX and VXTYN?

A: The VIX is derived from S&P options and the VXTYN is derived from Treasury Note options prices. VXTYN is a pure and simple way to hedged fixed income volatility on the 10-Year futures contract. We have approval to list out 12 months, but we’re going to begin by listing four months starting with January.

Q: How is the index calculated?

A: It is calculated the same way as the VIX, essentially. We take all the data points from the near term and first deferred out-of-the-money calls and puts, and we take a weighted average so we can take the implied volatility of all the strikes to capture the skew and interpolate between the two expiries to create a constant 30-day expected volatility. It’s identical to the VIX calculation except that the VIX has more strikes – somewhere around 200. For the VXTYN we will use about 20-25 strikes, depending on the quotes that are populated with non-zero bids.

Q: What is unique about this contract?

A:  This is the first time that customers will have a way to hedge pure interest rate volatility risk based on U.S. government debt with a single product. Also, in many instances, when exchanges create standardized contracts they typically face direct competition in the over-the-counter (OTC) space. In this instance, there are only a small number of products in the OTC space, so there is no meaningful direct competition from OTC. We’ve been talking to sell-side dealer banks, who have embraced this initiative. Sometimes these banks are reluctant to embrace a listed counterpart due to direct competition, but here there is not one of any consequence that will preclude them from participating. We have been hearing that directly from them.

We have just concluded a market making program. Three firms have agreed to provide liquidity from day one. These are participants not from our typical pool of equity derivative market makers, but they are proficient in making markets in listed futures and options on the floor of the CBOT and CME.

Q: What effect does the ending of QE have on the index and the need for this contract?

A:  In mid-October there was some interest-rate driven volatility, as the market anticipated not only the conclusion of QE but the next potential rate hike. It is a function of when the rate hike will occur, as well as the duration and magnitude of the rate hike. Those variables will factor into interest rate volatility. That’s why we are very excited about the timing of the launch. We will be in front of all this debate and speculation, which will add to fixed income volatility.

Q: How large is the market for interest rate derivatives?

A: It all depends on how you define it. Technically, if you look at both the listed and OTC markets, it is about 40 times bigger than the equity derivative space in terms of notional value outstanding. While we are not expecting the market for VXTYN products to be 40 times bigger than the VIX, we do think it offers a lot of potential. The market for interest rate derivatives has been around for 25 years, and the products currently in use work pretty well and are very liquid and transparent. We have no misconceptions that VXTYN will replace what market participants are currently using to hedge tail risk exposure. But it will be another tool in their toolbox to overlay their existing strategies.

Q: What are you hearing from potential users of the contract? Are they a different group than CBOE is accustomed to dealing with on the equity volatility side?

A: Yes, this is a whole new user group. It is primarily fixed income portfolio managers, asset managers like the Blackrocks and Pimcos of the world, as well as mortgage REITs and mortgage-backed security traders – people with direct and indirect exposure to U.S. interest rates.

Other sectors also have an interest. We have talked to many global-macro hedge funds and volatility-arbitrage funds. Many of the vol-arb funds are already trading interest rate volatility in other formats. What they find of value in this product is that it is a very simple, pure, economically efficient way to construct a trade they have already been involved in. Once they put the trade on they don’t have to continue to delta hedge that position, which is very resource-intensive. That is the advantage these contracts will have over equity options.  Many people trade volatility in the listed options space with straddles and strangles, for example, but in order to isolate the expected volatility component, they have to hedge that position continuously.

In addition, the global macro guys find the product a great way to capture event risk around interest rate moves stemming from economic releases such as non-farm payrolls and FOMC announcements.

Q: Do you foresee an options contract on the VXTYN?

A: A lot of things are on the table. We’d like to list options on these futures. In addition, we’ve already been approached by a number of exchange-traded product originators who want to create ETNs and ETFs on the product. That usually doesn’t happen until a product has a lot of liquidity and open interest, but we have already been approached. That says a lot for the potential the product has in the marketplace.

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