Volatility Managed Indexes: The Importance of Intraday Data

Abstract

Modern volatility managed indexes employ antiquated close-to-close volatility models to scale exposure. This has material consequences on the option pricing dynamics for structured investments, many of which reference a volatility managed index because of option pricing benefits associated with the constant volatility. The author tests two daily close-to-close models and three intraday “realized volatility” models that leverage the rich information dynamics found in intraday data. The results, across three highly liquid US large-cap indexes, suggest that the latter three models produce more consistent volatility profiles, or alternatively, a lower volatility of volatility, without sacrificing performance (i.e., the Sharpe ratio). All else being equal, this lower volatility of volatility should be preferred by product issuers and investors because of the resulting option pricing benefits.

Key Findings

• ▪ The interaction between intraday data and the structured investments market is largely undocumented.

• ▪ Volatility managed indexes use an antiquated, 25-year-old close-to-close volatility model that provides inferior option pricing consistency when compared with “realized volatility” models.

• ▪ Demand for structured investments, particularly those that are principal protected, is growing as a result of recent volatility, aging populations, and current fixed-income market forecasts, making the results herein of great interest to many market participants, ranging from derivative desks all the way to retirees.