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Volatility products: Vix takes sting out of tail risk

Investors more active in hedging market tail risk; Exchange traded products may be skewing volatility curve

Two years after the peak of the financial crisis the tail risk that defines such events has not been forgotten, in the equity markets at least.

In the universe of equity volatility products (Vix), there has been an ever-increasing demand for Vix products to hedge equity market tail risk and other equity exposures, which is attracting new market participants and new trading strategies. The average monthly trading volume in Vix futures on the Chicago Board Options Exchange has almost quadrupled this year compared with the same period last year, while in May volumes were 8.5 times the average of the year before, as a result of the May 6 flash crash and the European sovereign crisis.

New pit

This increased activity has prompted the CBOE to convert a large unused trading pit into a space for buying and selling Vix products, because there’s no longer enough room in the old pit for all the traders. Much of the increased trading seems to be centred on hedging tail risk – in other words, an unforeseeable event in the future, say analysts. It’s creating an unusual dynamic between the CBOE Volatility Index, the main indicator of market movement for the next 30 days, and Vix futures, which give a longer-term view of investors’ fears about shifts in the market.

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