Written on 19 September 2013.
Regional factors matter when it comes to volatility indicators—the study suggests that derivatives on Asian volatility should therefore be of genuine interest to investors.
The study finds strong evidence for a very significant local volatility factor in the Asian market index returns. In particular, the analysis reveals that the relationship between the Asian equity index returns and the Asian model-free option-implied (MFOI) volatility indices is significantly stronger than the relationship between Asian equity index returns and VIX. The analysis suggests either a weaker or insignificant relationship between the Asian equity market returns and the US VIX in the presence of Asian volatilities, implying that the Asian volatility indices can absorb the information content of the VIX.
This research calls into question the conclusions of previous academic studies and especially the popular idea with professionals that in a period of strong turbulence the recorrelation of the markets and their volatility would suggest the use of a very liquid contract like the VIX futures, which would thereby play a role of global protection against the strong risks of volatility, whatever the portfolios’ geographical exposure.
There are two implications of the work for investors with an exposure to Asian equity markets and for Asian volatility derivative markets:
1. An exposure to VIX is efficient most likely in very brief periods around significant volatility spillovers from the US market. Generally, an exposure to VIX for hedging an exposure to Asian equity markets is significantly less efficient than an exposure to an Asian MFOI volatility indicator.
2. From a practical perspective, constructing an exposure to an Asian MFOI volatility indicator is currently very difficult because of the limited liquidity of the volatility futures market. Nevertheless, the results of the study suggest that investors may be able to benefit greatly in the future as the market grows and liquidity increases, especially if their horizon is from a few days up to one week. This factual observation justifies the attempts to develop regional markets for volatility contracts, even if they are less liquid than the US market.
A copy of “The Local Volatility Factor for Asian Stock Markets” can be downloaded via the following link: