VXX Investment Thesis 2012-11-18 Mo Boonipat

iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA: VXX)

(Issue date: February 3, 2009; Maturity: January 30, 2019) Investment Thesis - Contango in the term structure of the VIX futures index lead to negative roll yield for products such as VXX that try to track the VIX by continuously selling the 1st month futures contract to buy the 2nd month futures contract. - Periods of backwardation such as during the financial crisis do not compensate for the contango over time. - Short position in the VXX will result in positive return over time because of the negative roll yield. Chicago Board of Exchange (CBOE) S&P Dow Jones Barclays

VIX Index

S&P 500 VIX Short-Term Index

VXX (iPath S&P 500 VIX Short-Term Futures ETN)

Calculated based on volatility from 30 days options on stocks

Calculated by continuously rolling st over a fraction of 1 month nd contract into the 2 month

Exchange traded notes (ETN) with value based on the S&P 500 VIX Short-Term Index. Holder can redeem the ETN with Barclays for NAV calculated using the same methodology

Risks Brief periods of backwardation, and hence positive roll yield, can result in substantial increase in VXX price. Therefore, a moderate position with enough margins for multiple folds increase in the price is essential to avoid forced buy-ins. Sustained backwardation as have never been recorded in the historic VIX futures data can result in substantial increase in price of VXX. Uncertain liquidity can result in trading risks. However, since Barclays can issue more ETNs at any time, and in periods of sustained backwardation there is likely going to be substantial interest in VIX products, the risk of a liquidity short squeeze is not substantial.

Figure 1: S&P Dow Jones S&P 500 VIX Short-Term Index normalized (value = 80,070.55 on 11/16/2007). Methodology: The index model returns from long VIX futures position that is rolled continuously throughout the period between futures expiration dates. The underlying contract is the 1st and 2nd month futures VIX contracts, with the 1st month rolling into the 2nd month. Source: S&P Dow Jones.
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VXX Investment Thesis 2012-11-18 Mo Boonipat

Figure 2: Normalized VIX index and VXX price, starting at issue date for VXX, February 3, 2009 Red: VIX. Blue: VXX. Sources: Yahoo! Finance

Figure 3: Daily percentage difference in price between the 1st month and 2nd month VIX contract, starting on inception date of futures on VIX on March 26, 2004. Roll yield = [(futures price 1st month) (futures price 2nd month)]/( futures price 1st month) Roll yield > 0 means backwardation; roll yield < 0 means contango. In total, there were 396 days with backwardation, and 2199 days total, for 18% of days with backwardation in this period (3/2004-11/2012) which included the financial crisis, the Arab spring, and the European debt crisis. Source: CBOE

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Figure 4: Normalized historical prices. Source: iPath S&P 500 VIX Short-Term Futures ETN Prospectus, PS-24

Figure 5: Theoretical calculation of change in value of $100 based on roll yield divided by 365 for each business day. Again note that periods of positive roll yield (backwardation) do not compensate for longer periods of negative roll yield (contango). Source: CBOE iPath S&P 500 VIX Short-Term Futures ETN Prospectus: The contracts included in the Indices have not historically exhibited consistent periods of backwardation, and backwardation will most likely not exist at many, if not most times. Moreover, many of the contracts included in the Indices have historically traded in contango markets. Contango markets are those in which the prices of contracts are higher in the distant delivery months than in the nearer delivery months. VIX futures have frequently exhibited very high contango in the past, resulting in a significant cost to roll the futures. The existence of contango in the futures market could result in negative roll yields, which could adversely affect the value of the Index underlying your ETNs and, accordingly, decrease the payment you receive at maturity or upon redemption. PS-12
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Definitions
ETN: An exchange-traded note (or ETN) is a senior, unsecured, unsubordinated debt security issued by an underwriting bank. Similar to other debt securities, ETNs have a maturity date and are backed only by the credit of the issuer. ETNs are designed to provide investors access to the returns of various market benchmarks. The returns of ETNs are usually linked to the performance of a market benchmark or strategy, less investor fees. When an investor buys an ETN, the underwriting bank promises to pay the amount reflected in the index, minus fees upon maturity. Source: wikipedia Roll yield: Backwardation occurs when a futures contract will trade at a higher price as it approaches expiration compared to when the contract is farther away from expiration. Rolling into less expensive futures contracts allows the trader to consistently profit from the rise in a futures' price as it nears expiration. The biggest risk to this strategy is that the market will shift to contango (opposite as backwardation). This type of changing market has led to major losses by various hedge funds in the past and is the reason why it should only be attempted by experienced traders. Source: investopedia.com A futures contract (more colloquially, futures) is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed today (the futures price or strike price) with delivery and payment occurring at a specified future date, the delivery date. Source: wikipedia

Contango is the market condition wherein the price of a forward or futures contract is trading above the expected spot price at contract maturity. The futures or forward curve would typically be upward sloping (i.e. "normal"), since contracts for further dates would typically trade at even higher prices. (The curves in question plot market prices for various contracts at different maturitiescf. term structure of interest rates) A contango is normal for a non-perishable commodity that has a cost of carry. Such costs include warehousing fees and interest forgone on money tied up, less income from leasing out the commodity if possible (e.g. gold). For perishable commodities, price differences between near and far delivery are not a contango. Different delivery dates are in effect entirely different commodities in this case, since fresh eggs today will not still be fresh in 6 months' time, 90day treasury bills will have matured, etc. The opposite market condition to contango is known as backwardation. Source: wikipedia
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