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Risk Premia and the VIX Term Structure

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What they found

Johnson showed that the slope of the VIX term structure (the difference between longer-dated and shorter-dated implied volatility) is a strong predictor of the returns to variance swaps, VIX futures, and S&P 500 straddles, while the level of the VIX is not. When the curve is steep, short-volatility positions earn more, and when it inverts, they lose. A single factor extracted from the term structure explains most of the predictable variation in volatility-related returns, and is only weakly related to subsequent realized volatility, so it reflects changes in the risk premium rather than in expected volatility.

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Contango and backwardationTwo futures curves against contract expiry: one rising above spot, one falling below it.The same commodity, priced for delivery at different dates.78.0076.0074.0072.0070.00Futures pricespot+1m+2m+3m+4m+5m+6mMonths until the contract expiresspot price74.00CONTANGOlater contracts cost more than spotBACKWARDATIONlater contracts cost less than spot
Contango and backwardation. A futures curve shows what buyers will pay for delivery in one month, two months and so on. When later contracts cost more than the spot price the curve is in contango; when they cost less it is in backwardation.

What you can use

  • The shape of the VIX curve, not its level, tells you how much you are being paid to sell volatility.
  • An inverted VIX curve (short-term above long-term) is when short-volatility positions have historically lost money.
  • Term-structure slope is a risk-premium signal, not a volatility forecast; use it for sizing volatility exposure, not for predicting the VIX.

Caveats

Sample 1996 to 2013 for the option-based series; strategies use variance swaps and straddles that are expensive for retail. Academic and technical.

Tags: volatility, vix, term-structure, variance-risk-premium

Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.