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Sunday, July 22, 2012

Rule of Thumb Analysis on Cost of Carry for VXX

Interest in VIX and VIX futures-related ETFs & ETNs have grown exponentially over the past few years.  Unfortunately, understanding of VIX futures-related ETNs, such as the most popular iPath S&P500 VIX Short-Term Futures ETN (VXX), has not kept up with the explosion of its trading.

For many who thought VXX was a good instrument to buy and hold, as a hedge against rising volatility, have suffered considerable losses.  Mainly, this is because of the cost of carry in the very futures instruments that VXX holds in its portfolio.

VXX is designed to replicate, net of expenses, the S&P 500 VIX Short-Term Futures Total Return Index. Basically, what this means is that VXX holds in its portfolio a combination of front month and second month VIX futures positions in order to maintain a constant 1-month forward VIX futures positions.  For example, at the start of a new expiration month (say August), VXX would be holding nearly 100% August VIX futures in its portfolio.  Two weeks to go to expiration, VXX would be holding roughly 50% August VIX futures and 50% September VIX futures.  As August expiration approaches, VXX would be holding closer to 100% September VIX futures position.  The daily performance of VXX would be similar to the weighted average daily price changes of the first two month VIX futures positions.

VIX futures are almost always in contango.  Contango means that each subsequent expiration month of VIX futures prices would be trading higher than the closer month's VIX future prices and the spot VIX overall (upward sloping curve).  The top graph (in blue) shows the average premium that VIX front month futures trades over Spot VIX with X number of days to go before expiration.  The red line shows the average premium that VIX second month futures trades over Spot VIX.  Finally, the Green line shows the daily average cumulative cost that VXX incurs to its portfolio by selling the front month VIX futures and buying second month VIX futures on a daily basis.  The average monthly cost that VXX incurs is around 6.5%.  This means that on any given month, even if VIX were to remain constant, VXX price would fall by 6.5% when VIX futures prices are in contango.

Remember, that when VIX rise above 25, VIX futures usually goes into backwardation.  Backwardation can be understood as the opposite situation as contango.  Backwardation begins to happen when Spot VIX is higher than front month VIX futures, and complete backwardation occurs (very rarely) when VIX futures prices of each subsequent expiration month is lower than the price of VIX futures in expiration months that are closer (downward sloping curve).  When VIX futures are in backwardation, VXX prices would theoretically rise as time passes, even if spot VIX were to remain constant.

As a rule of thumb, from the beginning of a new expiration month, for each trading day VXX could fall on average 0.25% as a result daily roll cost from contango.  With 5 days to go before expiration, VXX could fall on average 0.45% each trading day.  Another way of looking at this is on a weekly basis.  With 4 weeks to go before expiration, the cost of daily roll from contango could be seen as 1.25% for each passing week, but during the final week before expiration, the cost of daily roll increases significantly to 2.25% for the week!

The second graph above plots the actual VXX prices (in red) since the beginning of 2012.  The black line represents theoretical VXX price taking into account the daily price change of VIX less the average daily cost of carry for VXX as calculated from this analysis.  As you can see, while the black line does not move exactly to actual prices of VXX, on a weekly and monthly basis, it moves very similar to actual VXX prices.

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