By Mark Shore
Summary: Utilizing a European volatility index for Pan-European volatility
In past articles, I’ve discussed the negative correlation between the VSTOXX® Volatility index and the EURO STOXX 50® Index and how the volatility index tends to rally when equities decline (downside volatility).
The recent passing of the Brexit vote on 23 June 2016 introduced immediate uncertainty and downside volatility to the global capital markets. The results of several upcoming European elections could introduce more uncertainty and volatility into the capital markets. According to Bloomberg News,[ii] 40 percent of the EU economy will be voting in 2017.
Does this discussion begin to identify a larger macro story of positive correlation behaviour of several European equity indexes? If so, could investors find potential utility in the VSTOXX® Futures volatility index?
When examining the correlation of several European equity indexes, Table 2 demonstrates the relatively high positive correlation among various European spot equity indexes and a relatively high negative correlation the equity indexes tend to experience relative to VSTOXX® spot. An initial observation indicates the volatility index may offer added value to multiple European equity indexes if the indexes tend to be positively correlated.
No one has a crystal ball to identify when equity markets will decline. The so-called rare “Black Swan” events have occurred several times over the last decade. Beginning in 2008 with the Financial Crisis and followed by the Greek Debt Crisis, and followed by the European Debt Crisis, and followed by the Chinese Financial Turmoil and followed by the Brexit vote. In each of these global macro events the five European stock indexes declined and VSTOXX® volatility index rallied.
As noted in Chart 3, the equity indexes tended to peak, decline and find support around the same time. This suggests when the global macro events occur, investing in equities geographically across Europe may not offer enough diversification to reduce the portfolio correlation risk and tail risk.
The returns in Table 3 are based on when the EURO STOXX 50® Index peaked and bottomed surrounding each event and how the VSTOXX® volatility index and the four European equity indexes behaved during each period. During the five volatile periods the five equity indexes experienced similar negative returns. In the same periods the VSTOXX® spot index rallied. This is in-line with the previous correlation data showing negative correlation of the VSTOXX® index to the European equity benchmarks.
Based on 5-day rolling returns, the front month futures contracts of the European indexes traded with similar returns prior to and post the Brexit vote. This offers some more evidence to the positive correlations among the respective European equity indexes discussed earlier.
When the 5-day rolling returns of front month VSTOXX® Futures is added to the chart, the negative correlation performance of VSTOXX® Futures becomes very pronounced relative to the front month futures contract of the four European equity indexes. Once again, the results may offer the option to employ VSTOXX® Futures with several European equity indexes besides the underlying EURO STOXX 50® Index.
In summary, when examining the correlations either as a static metric or as a rolling metric, the correlations of the European equity indexes tend to maintain a high positive correlation frequently above 0.8 to the EURO STOXX 50® Index. During the various volatile periods the equity indexes tended to peak, decline and bottom around the same time. On the flipside, VSTOXX® volatility index tends to maintain a relatively high negative correlation to these respective equity indexes.
When viewing the most recent macro event (Brexit), on a rolling 5-day return, the returns tended to behave in similar fashion to each other leading up to and post the Brexit vote. Combining all of these results strongly suggests an investor with exposure to one or many of these European equity indexes may find an added value in utilizing VSTOXX® Futures to reduce portfolio tail risk and correlation risk.
By Mark Shore, Founder www.shorecapmgmt.com
Mark Shore has more than 25 years of experience in the futures markets and managed futures, publishes research, consults on alternative investments and conducts educational workshops. His research is found at www.shorecapmgmt.com
Mr. Shore is also an Adjunct Professor at DePaul University's Kellstadt Graduate School of Business where he teaches a graduate level managed futures/ global macro course. Mr. Shore is a frequent speaker at alternative investment events. He is a contributing writer for Eurex Exchange, CBOE, Swiss Derivatives Review, MicroCap Review and Seeking Alpha. Mr. Shore graduated from DePaul University with a degree in Finance. He received his MBA from the University of Chicago.
Past performance is not necessarily indicative of future results. There is risk of loss when investing in futures and options. Futures can be a volatile and risky investment; only use appropriate risk capital; this investment is not for everyone. The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.
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