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EQUITY RESEARCH Equity Linked Strategies | U.S.

Derivatives Strategy | February 24, 2010

SPECIAL REPORT Maneesh Deshpande


+1 212 526 2953
VIX ETNS: A User’s Manual maneesh.deshpande@barcap.com
BCI, New York

Rohit Bhatia
Since their introduction in early 2009, the VIX Futures ETNs (the VXX and +1 212 526 0367
VXZ), have gained prominence as alternative vehicles to trade volatility and rohit.bhatia@barcap.com
have made volatility as an asset class accessible to a broad range of investors. BCI, New York

In this report we collect together the numerous queries we have fielded from
investors around these products. It is organized in the form of FAQs
(Frequently Asked Questions) which should make it more convenient as a
reference manual for investors. We also elaborate on many topics we had
discussed in our previous publication (dated February 3, 2009): Towards an
Investable Volatility Index.

Barclays Capital does and seeks to do business with companies covered in its research reports. As a result,
investors should be aware that the firm may have a conflict of interest that could affect the objectivity of
this report.

Investors should consider this report as only a single factor in making their investment decision.

PLEASE SEE ANALYST CERTIFICATION AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 17.
Barclays Capital | U.S. Derivatives Strategy

FAQs (Frequently Asked Questions)

Structure and Dynamics


„ 1. What are VIX ETNs?

„ 2. Why do these ETNs track VIX Futures rather than the VIX Index?

„ 3. What is the relationship between moves in the VIX index and the VIX ETNs OR why is
the VXX only up 6% when the VIX is up 10% today?

„ 4. Why did the VXX drop by 65% during 2009 when the VIX only dropped by 46% OR
what is roll yield?

„ 5. Why are VIX futures underlying the VIX ETNs rolled on a daily basis?

„ 6. Why is the roll yield for VXX more than that of VXZ?

Hedging
„ 7. Why are VIX ETNs good equity portfolio hedges OR what is their correlation with the
equity market?

„ 8. How do I decide how many VIX ETNs I should buy to hedge my portfolio OR what is
the appropriate hedge ratio?

„ 9. What do I get for paying the roll yield OR how are VIX ETNs similar to puts?

„ 10. How effective have these products been as hedging vehicles? How do they compare
to hedging with puts?

„ 11. Can these products also be used to hedge other asset classes?

Investment
„ 12. How can VIX ETNs be used to express a view on the equity market?

„ 13. I think the VIX index will go up in the future. How do I choose between VXX and
VXZ?

Miscellaneous
„ 14. How liquid are VIX ETNs?

„ 15. How is the current value of VXX and VXZ related to volatility levels?

„ 16. What is the vega imbedded in a VIX ETN?

„ 17. How can I get a longer term history of VIX ETNs?

Appendix
„ VIX Futures Index Calculation

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Barclays Capital | U.S. Derivatives Strategy

Structure and Dynamics

1. What are VIX ETNs?


VIX ETNs (the VXX and VXZ) are Exchange Traded Notes whose performance is
benchmarked to VIX Futures indices published by S&P. VXX is based on the S&P VIX Short-
Term Futures index (SPVXSTR) and maintains a rolling long position in the first and second
month contracts while VXZ is based on the Mid-Term Futures index (SPVXMTR) and holds
the fourth to seventh month contracts.

Recall that VIX futures are future contracts which settle to the value of the VIX index at
expiration. Thus while the VIX index measures the option market’s estimate of the volatility
over the next 30 days, a VIX future is an estimate of the expected volatility for the 30 day
period starting on its expiration date.

Figure 1: Volatility Products: The Fourth Generation

Vanilla options Variance swaps VIX VIX-based ETNs


• Unhedged straddles • Spot variance • Futures • VXX
• Delta-hedged options • Forward-starting • Options • VXZ

Path dependency Constant gamma Constant vega exposure Opens vol to all investors
Operational difficulty Linearly changing vega Listed contracts Constant maturity exposure
Non linear decay Convex exposure Need for managing roll Daily creation/redemption
OTC only Transparent, liquid market

Source: Barclays Capital

As shown in Figure 1, VIX ETNs are the fourth generation of pure volatility products. While
vanilla options could be dynamically hedged to express a pure view on volatility, the path
dependency and operational overhead of the regular rebalancing made this non-trivial. The
introduction of variance swaps, whose payoff is simply the difference between the (square
of) actual realized volatility and a fixed strike, overcame these deficiencies to a large extent.
However, since these are OTC instruments, they could only be used by a limited number of
market participants. The introduction of the (exchange traded) VIX futures significantly
broadened the investor base. The introduction of the VXX and VXZ is the latest step in this
evolutionary chain.

2. Why do these ETNs track VIX futures rather than the VIX index?
This is because the VIX index is not a tradable index in the sense that it is not possible to
directly gain exposure to the change in its level across two dates. This is because as shown
in Figure 2, the VIX at any given point in time measures the markets expectation of volatility
over the next (rolling) 30 days. Thus on two different dates the VIX reflects volatility
expectations over two different periods which are not directly comparable.

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Barclays Capital | U.S. Derivatives Strategy

Figure 2: The VIX index on different dates refers to different time periods

VIX Index on Jan 20


April VIX Future on Jan 20

Jan 20 Feb 20 April 15 May 15


VIX Index on Jan 15 April VIX Future on Jan 15

Jan 15 Feb 15 April 15 May 15

Source: Barclays Capital

Note that it is possible to lock in the current value of the VIX index by entering into a
variance swap whose payoff is proportional to the difference between (the square of) the
VIX index and the actual subsequent realized volatility. However, the change in value of the
variance swap over a given period of time (say one week) will depend on the realized
volatility over these 5 days (the accrued P&L) and the volatility expectations over the next
25 days (market-to-market P&L). The value of the VIX index after one week will of course
correspond to the volatility expectation over the next 30 days. Thus the P&L of the variance
swap over these five days will not equal the change in VIX index.

However, a similar problem does not arise for VIX futures which measure volatility
expectations over a future time window as long as they are rolled prior to expiration. Thus
prior to expiry, the changes in value of the VIX futures correspond simply to the change in
these expectations. This situation is very similar to that for interest rate futures with the
LIBOR index and Eurodollar futures being similar to the VIX index and VIX futures
respectively.

3. What is the relationship between moves in the VIX index and the VIX
ETNs (or why is VXX only up 6% when VIX is up 10% today?)
As discussed above, it is important to realize that VXX and VXZ are not supposed to track
the VIX index but VIX futures. While the value of the VIX index on any give date corresponds
to the market’s expectation of SPX volatility over the next 30 days, the value of a VIX future
is the markets’ expectation of volatility over the 30 days subsequent to the future expiry.

The key point is that changes in market expectations of volatility are not uniform over all
future dates. Since typical risk flares are short lived affairs, adverse macroeconomic news
will typically lead to a larger increase in short term volatility expectations. As a result, VIX
futures will not react as much as the spot VIX index. Of course, in some cases, the change in
volatility environment is viewed to be relatively more permanent and then the change in
volatility term structure might be more of a parallel shift. As a result, both the volatility of
VIX futures and their correlation with the spot VIX index decreases with an increase in their
expiration date. Consequently, as shown in Figure 3, the beta of the VIX futures relative to
the VIX index (i.e. the typical move of VIX futures for a 1% move in the VIX index), which is
a product of these two factors decreases with increasing maturity. The same figure also

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Barclays Capital | U.S. Derivatives Strategy

shows the betas for VXX and VXZ. As a rough rule of thumb, the typical moves in the VXX
and VXZ are only 50% and 20% that of the VIX index.

Figure 3: Beta of VIX futures relative to VIX

0.6
0.5

0.4

0.3
0.2

0.1

0
1 Month 2 Month 3 Month 4 Month 5 Month 6 Month VXX VXZ
VIX VIX VIX VIX VIX VIX
Future Future Future Future Future Future

Beta of VIX Futures vs VIX


Source: Barclays Capital

4. What is the roll yield in the VIX ETNs (or why did VXX drop by 65% during
2009 when the VIX only dropped by 46%)?
As discussed in FAQ 3, daily returns of the VXX are on average smaller than that of VIX. It
might then seem paradoxical that the cumulative drop over 2009 in VXX was much more
than VIX (Figure 4).

Figure 4: VXX has underperformed the VIX index

120
110
100
90
80
70
60
50
40
30
20
Jan-09 Apr-09 Jul-09 Oct-09 Jan-10

VIX VXX VXZ


Source: Barclays Capital, Bloomberg

The answer to this conundrum lies in the fact that the total return from holding a futures
position over an extended period of time will also depend on the slope of the futures curve
(the so called roll yield).

Consider the following simple scenario. Suppose on Jan expiry, the value of the VIX index is
15 and we are long 100 contacts of the Feb VIX future which is trading at 30. In one month,

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Barclays Capital | U.S. Derivatives Strategy

a few days before the February expiry, we will have to roll our February futures. Consider
what happens if the market’s view on volatility has not changed so that the VIX index (and
the February future) is trading at 15 and the March future (which is now the one month
future) is trading at 30. Then, we will only be able to buy 50 contracts of the March future
using the proceeds obtained by selling the 100 Feb futures. Thus if the futures curve
consistently stays upward sloping (in contango) holding a self funded futures position will
result in a drag in performance. Of course if the curve is upward sloping (in backwardation),
the above roll cost turns into a “roll profit”.

Figure 5: The total return of a futures position also needs to incorporate the roll yield

20%

19%

18% Roll at maturity Yield


VIX Future

for 3M future
17%

16%
Roll at maturity Yield
15% for 1M future

14%
0 1 2 3 4 5 6 7
Expiration (Months)

Source: Barclays Capital

We emphasize that the above considerations apply to any future contracts. For future
contracts on actual assets (e.g. commodities, equity indices) this cost to a large degree
reflects actual costs such as interest rates, storage costs, etc which would be accrued by
investing in the physical asset. The situation for futures on non tangible assets such as VIX
or LIBOR is not so clear cut. The S&P indices underlying the VXX and VXZ essentially
replicate the performance of holding a set of VIX futures and thus are also subject to the roll
dynamics discussed above.

The key question then becomes: is the VIX futures curve typically in contango or
backwardation? Given the limited history of VIX futures (they were only listed in 2005), we
use theoretical variance swaps to answer this question, Figure 6 shows our estimate of the
roll yields for VXX and VXZ. Clearly, the VIX futures tend to be in contango during low
volatility periods and go into backwardation during risk flares.

In particular over this 18 year time period, the median VXX roll yield has consistently
averaged ~10% during the low volatility periods and can spikes to very large negative values
(-20%) during crises periods. The overall median value for the whole time period is ~3%.

As we discuss in more detail in FAQ 6 below, the roll yield for VXZ is much lower than VXZ.
Even during low volatility periods it is only in low single digits and the overall median is
actually zero.

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Barclays Capital | U.S. Derivatives Strategy

Figure 6: VIX Futures are typically in contango (backwardation) during low (high)
volatility regimes

20% 90
15% 80
10% 70
5%
60
0%
50
-5%
40
-10%
30
-15%
-20% 20
-25% 10
-30% 0
Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10

Est. VXX Montly Roll Cost Est. VXZ Monthly Roll Cost VIX(RHS)
Source: Barclays Capital, CBOE, Bloomberg
Note: VXX estimated roll yield = 0.5*(2M VIX Future – VIX)/1M VIX Future
VXZ estimated roll yield = 0.5*(6M VIX Future – 4M VIX Future)/4M VIX Future
The N-month VIX futures are obtained by interpolating Variance Swap strikes

A simple way to quantify the roll yield imbedded in these products is to calculate the
performance of a (fictitious) constant maturity future calculated via interpolation. This
allows us to separate the effect of simply the price level shift on the VIX ETNs. Thus if the
term structure of VIX futures was always completely flat, the two time series would be
identical. Figure 7 shows the result for both VXX and VXZ since the beginning of 2005.

Figure 7: Roll Effect on VXX and VXZZ

600

500

400

300

200

100

0
Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09

VXX VXZ 1M VIX Future 5M VIX Future


Source: Barclays Capital, Bloomberg

5. Why are the VIX futures underlying the VIX ETNS rolled on a daily basis?
While the futures imbedded in any futures based strategy need to be rolled prior to
expiration, there is considerable flexibility regarding its timing. The simplest methodology
followed by several commodity-based ETFs is to roll a few days before expiration. The S&P
VIX Future indices instead roll on a daily basis for three primary reasons:

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Barclays Capital | U.S. Derivatives Strategy

„ As discussed above, the primary cost in holding these instruments is the roll yield due to
the typically upward sloping term structure of VIX futures. However, as shown in Figure
8, the term structure typically flattens out with increasing maturity. Indeed if the slope
had been perfectly linear, there would no material difference between rolling daily or at
expiration. The roll yield depends on the slope of the line connecting the two points on
the futures curve where the roll is done. Since the VIX futures curve flattens out with
increasing maturity, it is clear that rolling daily should be less expensive. This effect is
quantified in Figure 9, where we show the underperformance of VXX if the roll is done at
futures expiry rather than daily.

Figure 8: VIX Futures curve is convex… Figure 9: Which makes rolling daily is better than rolling at
expiration
26 250
25
VIX Futures Level

24 200
23
22 150
21
20 100
19
18 50
17
1 14 42 70 105 133 161 195 225 0
Days to Expiration Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09

Vix Futures as of Jan 6 VXX Rolled at expiration VXX Rolled daily

Source: Barclays Capital, Bloomberg Source: Barclays Capital, Bloomberg

„ If the roll were to be done prior to expiry, the entire future position underlying the
product would have to be rolled over a few days and would likely cause excessive
market impact. This is likely to be exacerbated given that the roll schedule would be
public knowledge. Doing the roll on a daily basis mitigates some of this market impact.

„ As discussed in FAQ 7, the beta of VIX futures with the equity market and the VIX index
decrease quite markedly with increasing maturities. As such holding the VIX future until
expiration would mean that the characteristics of the instrument would not be constant
across time since we would be effectively holding a shorter-dated VIX future for some
part of the cycle.

6. Why is the roll yield for VXX more than that of VXZ?
As discussed in FAQ 4, the roll yield depends on the slope of the line connecting the two
points on the futures curve across which the roll takes place and VIX futures curve flattens
out with increasing maturity (Figure 8). Since VXX holds the first and second month futures
and the VXZ holds the fourth to seventh month futures, the roll yield of the former is much
higher on average. Hence as shown in Figure 11, the roll yield for VXZ is much lower than
VXX.

A more precise methodology would be to fit an exponential function to model the


relationship between VIX futures levels and time to expiration (Figure 10) and assume that
on each subsequent day this curve (as a function of expiration) would remain constant. The
roll yield for VXX and VXZ can then be determined by following the rolling methodology
which has been defined for these instruments. Obviously, this estimate of the roll yield
depends on the current shape of the curve. Figure 11 we show the estimate of the roll yield

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Barclays Capital | U.S. Derivatives Strategy

using the futures curve on Jan 6, 2010. On this date, under an assumption of a constant
volatility term structure, the monthly roll yield in VXX will be -10.7% and only -0.39% in
VXZ

Figure 10: Exponential function fits the Futures Curve well Figure 11: Roll yield is Higher in VXX Relative to VXZ

26 102
25 100
24 98
Futures Price

23 96
94
22
92
21
90
20
88
19 86
18 84
0 14 42 70 105 133 161 195 225 82
Days to Expiration 6-Jan 11-Jan 16-Jan 21-Jan 26-Jan 31-Jan 5-Feb

Future Values Fitted Value VXX VXZ

Source: Barclays Capital, Bloomberg Source: Barclays Capital, Bloomberg

Hedging

7. Why are VIX ETNs good equity portfolio hedges OR what is their
correlation with the equity market?
As has been widely documented, volatility is negatively correlated with the equity market
and tends to rise during sell off. As a result, VIX futures are themselves negatively
correlated with SPX as shown in Figure 12. Hence a long position in the VIX ETNs is likely to
serve as a hedge for an equity portfolio.

Figure 12: Volatility of VIX futures and correlation versus Figure 13: Leading to beta doing the same.
SPX both decline with maturity…

60% 0.0

40% -0.1
20%
-0.2
0%
-0.3
-20%
-0.4
-40%

-60% -0.5

-80% -0.6
F1 F2 F3 F4 F5 F6 F7 VXX VXZ F1 F2 F3 F4 F5 F6 F7 VXX VXZ

Volatility Correlation vs SPX Beta vs SPX

Source: Barclays Capital, Bloomberg Source: Barclays Capital, Bloomberg


Note: Volatility and correlation calculated using overlapping weekly returns from Note: Volatility and correlation calculated using overlapping weekly returns from
2006-Current 2006-Current

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Barclays Capital | U.S. Derivatives Strategy

Figure 12 also demonstrates that the correlation of constant maturity VIX futures with SPX
decreases gradually with increasing maturity. The next FAQ addresses the question of how
to determine the hedging amount.

8. How to determine the amount of VIX ETNs I should buy to hedge my


portfolio OR what is the appropriate hedge ratio?
Since VXX & VXZ are tradable assets, calculating their hedging ratio would follow the
familiar method of calculating the beta of the portfolio with respective to the asset. Recall
that the beta gives the size of the hedge which minimizes the standard deviation of the
portfolio and can be written as:

σ SPX
β =ρ
σ VXZ
Knowing the correlation and the volatilities, this can be easily calculated. Thus as compared
to say buying puts (where the notional can be simply assumed to be the equity notional),
this requires an additional estimation.

In order to examine the stability of the beta over time we plot the three-month rolling
correlation of VXZ and VXX vs SPX weekly returns in Figure 14. We note that since the
history of the S&P Mid-Term index is only available since 2005, data prior to that uses
theoretical index values calculated using SPX option data. While consistently negative, there
is clearly substantial variation in this correlation. The rise in correlation since 2008 is an
encouraging feature and we believe implies that hedges using these indexes would become
more effective during periods of stress.

Figure 14: SPX correlation with VXZ has declined from Q4 Figure 15: While the beta has also declined since the crises
2008

0% 0

-0.2
-20%
-0.4
-40%
-0.6
-60% -0.8

-80% -1

-1.2
-100%
Apr-96 Sep-98 Jan-01 Jun-03 Nov-05 Mar-08
Apr-96 Apr-99 Apr-02 Apr-05 Apr-08
3 Month Beta (VXX vs SPX Weekly Returns)
3 Month Correlation (VXX vs SPX Weekly Returns)
3 Month Beta (VXZ vs SPX Weekly Returns)
3 Month Correlation (VXZ vs SPX Weekly Returns)

Source: Barclays Capital, Bloomberg Source: Barclays Capital, Bloomberg


Note: Prior to 2005 we use theoretical values calculated using SPX options Note : Prior to 2005 we use theoretical values using calculated SPX options

The corresponding beta is plotted in Figure 15. The VXZ beta remained close to 0.4 before
the second half of 2008, where the market turmoil increased this to close to 1, primarily
driven by the large increase in the volatility of SPX. The change in correlation (Figure 14)
and that in the volatility of VXZ itself was much more muted. The pullback in equity
markets in 2009 has resulted in the beta moderating to 0.4.

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Barclays Capital | U.S. Derivatives Strategy

9. What do I get for paying the roll yield OR how are VIX ETNs similar to
puts?
If the returns of these instruments were to be linearly related to SPX, using them as a hedge
for a SPX portfolio would be tantamount to simply reducing the exposure and going to cash
and/or going short SPX futures. Indeed, these instruments can certainly be used for this
purpose.

However, as shown in Figure 16 and Figure 17, the returns of these instruments have
asymmetrical exposure to SPX returns. The roll yield can thus be thought of as being the
cost that the investor pays for being long this convex payoff.

Figure 16: Convexity of VXX returns versus SPX returns Figure 17: Convexity of VXZ returns versus SPX returns

120% 50%
100% 40%
80%
VXX Monthly Return

VXZ Monthly Return


30%
60%
20%
40%
10%
20%
0%
0%
-20% -10%

-40% -20%
-60% -30%
-50% -30% -10% 10% 30% -50% -30% -10% 10% 30%
SPX Monthly Return SPX Monthly Return

Source: Barclays Capital, Bloomberg Source: Barclays Capital, Bloomberg

Note: Overlapping monthly returns from 2006 - Current Note: Overlapping monthly returns from 2006 - Current

10. How effective have these products been as hedging vehicles? How do
they compare with hedging with puts?

As we have shown in previous sections, VXX and VXZ are convex instruments. In that
respect they resemble the payoff of puts. The cost of being long these ETNs is the daily roll
yield which is similar to the daily theta in the case of puts.

To determine whether these ETNs have performed well as hedges of a long SPX portfolio,
we compare their performance relative to puts. We calculate the monthly return of a long
S&P portfolio hedged with 50 delta 1 month & 12 month puts. In the case of the 12 month
puts, we assume that they are rolled monthly.

We use the rolling weekly returns over the past year to calculate the required beta of VXX
and VXZ on any given date. In all these instances, we assume that we have an equal amount
of cash to invest which is allocated between an SPX position and VIX ETNs or puts.

The performance of the various hedges since Dec 20, 2005 is charted in Figure 18. Both the
VXX & VXZ hedge were successful in reduced losses during the 2nd half of 2008, but in
return have underperformed the long SPX portfolio in 2009.

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Barclays Capital | U.S. Derivatives Strategy

Figure 18: Puts vs. VIX ETNs: Hedges for Long SPX Portfolio

140

130
120

110

100
90
80

70
60

50
Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09
SPX SPX + 1 Month 50 Delta Put
SPX + 12 Month 50 Delta Put SPX + VXX
SPX + VXZ
Source: Barclays Capital, Bloomberg

More quantitatively, hedging SPX with VXZ has performed the best according to the risk
adjusted return metrics like the Sortino Ratio and the Sharpe Ratio as shown in Figure 19.
While hedging SPX with a rolling 12 month put has performed better than hedging with 1
month put, both VXX and VXZ have performed better as hedges.

Figure 19: VIX ETNs have performed better as hedges

SPX + 1 SPX + 12
Month 50 Month 50 SPX + SPX +
SPX Delta Put Delta Put VXX VXZ
Avg Monthly Excess Return -0.29 -0.41 -0.01 0.16 0.32
Std Dev of Excess Returns 5.93 2.12 1.94 2.44 2.40
Sharpe Ratio -0.17 -0.66 -0.01 0.23 0.46
Sortino Ratio -0.19 -0.84 -0.01 0.35 0.66
Source: Barclays Capital, Bloomberg

We further analyze the performance of VXZ as a hedge for a long SPX portfolio. Since 2006,
it has succeeded in reducing the volatility of SPX monthly returns while increasing the
average monthly return. While adding VXZ to the portfolio improves performance during
periods of stress, it does not worsen performance significantly during strong market
conditions and having a lower hedge ratio helps in times of low volatility. In Figure 20 we
show how using a low beta of 0.4 for VXZ would have still allowed for an effective during
the 2nd half of 2008. Beta of 0.4 corresponds to an asset allocation of 28.6% for VXZ and
71.4% to SPX.

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Barclays Capital | U.S. Derivatives Strategy

Figure 20: Back-test Performance of SPX hedged with VXZ (Constant beta of 0.4)

140
130
120
110
100
90
80
70
60
50
Dec-05 Jun-06 Dec-06 May-07 Nov-07 May-08 Oct-08 Apr-09 Oct-09

SPX Hedged with 40% VXZ SPX


Source: Barclays Capital, Bloomberg

11. Can these products also be used to hedge other asset classes?
These products can also be used to hedge for other asset classes. Any asset which is
correlated to the equity markets will also be correlated to the VIX ETNs even though this
correlation may be weaker that that between SPX and the ETNs. The volatility ETNs have a
high correlation with multiple asset classes as shown in Figure 21.

For a more detailed discussion of the use of these ETNs for hedging other asset classes
please see our previous publication: Towards an Investable Volatility Index, 2/3/09.

Figure 21: Cross asset correlations in 2009

US US
CDX CDX SPVX SPVX
SPX RTY EEM Trsy Trsy EUR BRL CRY
HY IG STR MTR
(3-5y) (20+)
SPX 100% 95% 92% 60% 75% -31% -27% 48% -65% 56% -84% -77%
SPVXSTR -84% -79% -80% -57% -67% 30% 25% -40% 61% -52% 100% 89%
SPVXMTR -77% -72% -75% -51% -63% 31% 29% -31% 58% -45% 89% 100%

Source: Barclays Capital

Investment

12. How can the VIX ETNs be used to express a view on the equity market?
Given its high (negative) correlation with the equity market, a long position in VXX can be
used to express a leveraged negative view on the equity market. The leverage arises since as
discussed in FAQ 7 since the beta of VXX relative to SPX is roughly 1.5. However, this
leverage does not come free and investments for longer period of time need to take the roll
yield into account.

13. I think the VIX will go up in the future. How do I choose between VXX
and VXZ?

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Barclays Capital | U.S. Derivatives Strategy

The answer to this question depends critically on the magnitude of the expected move and
the time horizon over which it is expected. Recall that as discussed in FAQ 3, a rough rule
the percentage move in VXX is roughly 50% of the percentage move in the VIX index and
that of VXZ is roughly 20%. On the other hand, as discussed in FAQ 4, the monthly roll yield
for VXX and VXZ are roughly 10% and 2% respectively. As a result, while the VXX will move
more the cost of carrying it is also larger.

Thus, as shown in Figure 22, for small expected moves in the VIX, the non-zero carrying
costs means that it would not make sense to have a position in either ETN. Using the above
sensitivities and roll yields, the breakeven VIX returns for VXX and VXZ are thus 20% and
10% respectively. In addition, VXZ is preferred over VXX until a VIX return of 25.5%.

The above analysis assumed a monthly horizon. The breakeven for preferring VXX will
become progressively lower for shorter time horizon. For a view that volatility is likely to rise
over the next few days, VXX is certainly the instrument of choice.

Figure 22: Relative attractiveness of VXX versus VXZ over a monthly horizon

10%

5% No Position Long VXZ

0%

-5%
Long VXX
-10%

-15%
0% 5% 10% 15% 20% 25% 30% 35% 40%
VIX Expected Return

VXX Total Return VXZ Total Return


Source: Barclays Capital
Note: We assume a monthly roll yield of 10% for VXX and 2% for VXZ

Miscellaneous

14. How liquid are these VIX ETNs?


Shares outstanding for the VXX have been steadily increasing and currently equal more
than 38 million. The market capitalization of VXX has also crossed the $1 billion mark. In
contrast, the increase in market cap of the VXZ has been slower and currently stands at
around $180 million (Figure 23).

However, it is important to realize that similar to any ETF, the actual liquidity of these
products is not limited to their direct secondary market liquidity. These instruments can be
obviously replicated by using VIX futures but variance swaps and vanilla options can also be
used to synthetically hedge/replicate these products. Thus while the total vega equivalent in
the VIX ETNs now stands at a respectable $50 million, it is far outstripped by the vega of
listed SPX options expiring in less than a year which is $800 million. Of course there is
additional liquidity available in the OTC SPX options and variance swaps. Similarly, while the

February 24, 2010 14


Barclays Capital | U.S. Derivatives Strategy

daily vega traded for the VIX ETNs now stands at around $9m, the corresponding number
for (less than on year) listed SPX options is ~$55m.

Figure 23: VIX ETN AUM has grown rapidly since launch… Figure 24: As have their daily traded value

1,400 600

1,200 500
1,000
400
800
300
600
200
400

200 100

0 0
Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10

VXX AUM($m) VXZ AUM($m) VXX Value Traded($m) VXZ Value Traded($m)

Source: Barclays Capital, Bloomberg Source: Barclays Capital, Bloomberg

15. How is the current value of VXX and VXZ related to volatility levels?
The numerical values of the VXX and VXZ are completely arbitrary and do not have any
relation to the current volatility levels. Both these ETNs were launched with initial (arbitrary)
values of 100 and the current value represents the total return since its launch plus 100.

16. What is the vega imbedded in a VIX ETN?


To be precise: given that VXX is trading at $30, how much will its price change if the one
month VIX future changes by 1 point? Note that by construction the vega of a VIX future is
fixed ($1,000 for a one point change).The problem is of course that as discussed above, the
number of futures imbedded in one share of VXX is not fixed due to the roll yield and indeed
depends on the history of the shape of the VIX futures since inception. However, percentage
changes in the VXX will still equal percentage changes in the VIX future. Thus the vega is
simply the ratio of the current price of a VIX ETN and the corresponding VIX future price
(the interpolated one month and five month future for VXX and VXZ respectively).

17. How can I get a longer term history of VIX ETNs?


VXX and VXZ were both launched January 29, 2009 and as such actual traded prices of
these products are only available since this date. However, since these are ETNs (Exchange
Traded Notes) they are guaranteed to track the underlying index (as opposed to ETFs where
the ETF manager tracks the index on a best effort basis). The underlying indices have been
calculated by S&P starting from December 20, 2005 when liquid VIX future prices became
available.

Prior to liquid VIX futures, one has to calculate theoretical VIX futures using listed options.
This necessarily involves some theoretical assumptions and more importantly interpolation
across listed strikes. In particular, the estimated roll yield is quite sensitive to the
methodology used and this remains an active area of research for us.

February 24, 2010 15


Barclays Capital | U.S. Derivatives Strategy

Appendix A

VIX Futures index calculation


On each business day, the excess return versions of the VIX futures indexes are calculated
based on the compounded contract daily returns, which are defined as:

TDWOt
CDRt = −1
TDWI t −1

Here TDWI t −1 is the total dollar notional invested as of the previous business day and is
calculated by multiplying the quantity of each contract held by its level:

n
TDWI t −1 = ∑ CRWi ,t −1 * DCRPi ,t −1
i =m

TDWOt or the total dollar weight obtained at the end of day t is the dollar notional
exposure based on changes in value for contracts held the previous day:

n
TDWOt = ∑ CRWi ,t −1 * DCRPi ,t
i=m

where m and n equal 1 and 2 for the short term futures index, and equal 4 and 7
respectively for the mid-term index.

The Daily Contract Reference Price, or DCRPi,t denotes the level at which each VIX futures
contract is trading. CRWi,t or the Contract Roll Weight indicates the number of contracts of
maturity i held on day t. For the short term index, this means starting with 100 units of the
first month contract at each VIX futures expiration rolling it in equal increments each
business day into the second month contract. In case of the mid-term index, the initial
position is 100 contracts each in the fourth, fifth, sixth and seventh months, with the fourth
month being rolled into the seventh in equal intervals. Thus, if there are 25 business days to
the next VIX futures expiration, the second day would see 96 contracts in the fourth month
to 4 units in the seventh month.

February 24, 2010 16


Barclays Capital | U.S. Derivatives Strategy

Analyst Certification:
I, Maneesh S. Deshpande, hereby certify (1) that the views expressed in this research report accurately reflect my personal views about any or all of the
subject securities or issuers referred to in this research report and (2) no part of my compensation was, is or will be directly or indirectly related to the
specific recommendations or views expressed in this research report.

Important Disclosures
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have a conflict of interest that could affect the objectivity of this report.

Investors should consider this communication as only a single factor in making their investment decision.

The analysts responsible for preparing this report have received compensation based upon various factors including the Firm's total revenues, a portion of
which is generated by investment banking activities.

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Risks:
„ Call or put purchasing: The risk of purchasing a call/put is that investors will lose the entire premium paid.
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„ Call or put calendar spread purchasing (different expiration months & short must expire prior to the long): The basic risk of effecting a long
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Because of the importance of tax considerations to many options transactions, the investor considering options should consult with his/her tax advisor as
to how taxes affect the outcome of contemplated options transactions.
Supporting documents that form the basis of our recommendations are available on request. The Options Clearing Corporation's report, "Characteristics
and Risks of Standardized Options", is available at http://www.theocc.com/publications/risks/riskchap1.jsp

Barclays Capital offices involved in the production of Equity Research:


London
Barclays Capital, the investment banking division of Barclays Bank PLC (Barclays Capital, London)

New York
Barclays Capital Inc. (BCI, New York)

Tokyo
Barclays Capital Japan Limited (BCJL, Tokyo)

São Paulo
Banco Barclays S.A. (BBSA, São Paulo)
Hong Kong
Barclays Bank PLC, Hong Kong branch (BB, Hong Kong)

Toronto
Barclays Capital Canada Inc. (BCC, Toronto)

February 24, 2010 17


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February 24, 2010 18

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