Regulations
Volatility of volatility!

Chicago Board Options Exchange has introduced an index VVIX which track the volatility of volatility of volatility index. Financial product “innovation” and “choice” are being taken to ridiculous lengths

So-called financial innovation, at least in the developed world, has grown exponentially over the past few decades. There are just simply too many new products to keep track of. Not only has the quantum of new products risen but the complexities have multiplied, stumping even the most astute financial observer. If you thought collaterised debt obligations (CDOs) which brought down the American economy to its knees were complicated enough, wait until you hear of the latest product introduced by the Chicago Board Options Exchange (CBOE) VVIX.

Volatility Index, or VIX, is a measure of volatility of the market. The VIX is the product of the CBOE and financial whiz kids known as quants who use elaborate mathematics to develop sophisticated products. The VIX is often used to gauge fear or greed in the markets. Sometimes it is also known as the “fear index”. The VIX measures the ratio of put options versus call options being bought on the S&P 500. When the market moves higher, the VIX goes down and vice versa. Thus, the market can be deemed ‘fearful’ when the VIX goes up. By dabbling in this product you are taking a call on the volatility of the markets vis-a-vis prevailing fear/greed.

But what does the VVIX do? As the symbol suggests it measures volatility of volatility of the markets! According to CBOE on its website, “VVIX reflects the market’s consensus of expected volatility of the 30-day forward price of the VIX Index and provides new information for investors looking to formulate trading strategies based on the relationship between the VIX Index and the volatility of the VIX Index.” In other words, the product seeks to achieve not how volatile markets are, but on the volatility of VIX. This is nothing but one complicated (mathematical) product atop of another, and would lead to confusion. It is a derivative of a derivative—meaning it is based on a product, which is based on something else. A normal F&O product would be based on one variable—the underlying stock price of the scrip. The new VVIX will reflect the market’s expectation for the 30-day forward price of the VIX based on options prices, according to a statement from the CBOE. One could imagine what a VVVVIX would look like.

The VVIX isn’t the only complicated product of its kind out there. There are funds of funds of funds. That’s right. A fund of fund is a specialist hedge fund investing in other hedge funds. However, a fund of fund of fund is when a hedge fund invests in a fund of fund hedge fund. Confused yet?
The table below will make it easier for you to understand.



Illustration of Funds of Funds of Funds

Similarly the VVIX does the same thing.



What we see common here is as you go higher in the hierarchy, the product complexity increases, where it becomes very difficult to track what exactly is happening to a product let alone the market.

The best example of this kind of product innovation gone haywire is the CDO, which is a product comprised of different kinds loans (credit card loans, car loans, education loans, mortgages, etc), each of different grades, seniority, tenure and interest rates (and many other factors), are lumped together to form a single product. This kind of product, while far too complex even to the sophisticated financier, is what brought down America’s economy to her knees. It becomes difficult to understand a CDO because it had several different kinds of loans inside it. Analysing a CDO meant understanding and tracing the origins of each and every loan to variety of customers, each having their own unique profile and credit-worthiness—a physically daunting task. If we were to track VVIX and Funds of Funds of Funds, we would need to track them the same way we would track a CDO—verifying each and every variable, which would be very difficult.

The proponents of financial innovation claim that risk is diversified and reduced. Indeed, diversification is effective but only to a certain extent beyond which it actually becomes dangerous and ineffective as we’ve seen what it did to the American economy. It also becomes very difficult for the investor to understand the product, no matter the benefits touted. Financial innovation, unlike other kinds of innovation, is intangible and is rarely beneficial which global regulators are beginning to understand slowly. Nobody except some smart traders will benefit from it, unlike an innovative phone or a computer.

The National Stock Exchange of India (NSE) has the India VIX product (http://www.nseindia.com/content/press/prs_vix.htm) though the VVIX hasn’t yet arrived in India.

John Maynard Keynes, the English aesthete, economist and trader figured out the ridiculousness of “financial innovation” of anticipating the anticipation long ago when he described the action of rational agents in a market using an analogy based on a fictional newspaper contest, in which entrants are asked to choose a set of six faces from photographs of women that are the “most beautiful”. Those who picked the most popular face are then eligible for a prize. He wrote “It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment Interest and Money, 1936).

User

COMMENTS

Krishnaraj Rao

5 years ago

Wow! Weird!!!! Height of craziness.

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