Volatility Term Structures of Individual Stocks

In 1993, the Chicago Board Options Exchange (CBOE) launched the Volatility Index (VIX), which became a crucial gauge for expected short-term market volatility. It serves as the foundation for trading volatility futures and portfolio hedging. Initially, the VIX was model-dependent and applied to the S&P100. Then, the CBOE developed a model-free VIX applied to the S&P500.

The majority of VIX research is centered around the S&P500 index. Reference [1] applied the same methodology developed for VIX but adapted it to individual liquid stocks. Specifically, it calculates 1-12 months VIX for Amazon, Apple, Goldman Sachs, Google, and IBM. The main findings are:

• The first important finding indicates that individual VIX indices exhibit a modest correlation with the aggregate VIX of the S&P 500, suggesting that much of the variation in individual stocks is firm specific. This finding holds true regardless of the maturity term.
• The second finding indicates that the VIX term structure of the individual stocks slopes upwards. The rise in VIX levels across various maturity periods for each stock could suggest that market participants anticipate volatility, potentially leading to fluctuations in individual stock prices.
• Third finding suggests that the variance risk premium is a promising indicator of where the security’s price is heading in the short run.
• Finally, given that the variance risk premium furnishes valuable information, we decompose its term structure and observe distinct pricing patterns for longer time horizons (see Figure 2). This result hints that investors seek greater compensation for the uncertainty surrounding the variance in returns in the distant future.

We find it interesting that the correlations between the VIX of individual stocks and the S&P 500 are rather weak, despite their similar structures and characteristics. This suggests that we can apply the same trading strategy developed for the S&P 500 to individual stocks and still achieve diversification.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Mahmoud Qadan, Or David, Iyad Snunu b, Kerem Shuval,  The VIX's term structure of individual active stocks, Finance Research Letters Volume 61, March 2024, 105036

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