Hedging VIX ETNs with Futures, Options, and Variance Swaps
Summary
The discussion considers how an issuer might hedge an ETN linked to a VIX strategy, especially when replicating an index with VIX futures could involve trading costs and limited liquidity in deferred contracts. The answers emphasize that a hedge need not reproduce the index perfectly: using S&P 500 options as a proxy can reduce the liquidity burden, but introduces tracking error. Comparing the ETN and a benchmark return series over time is suggested as a way to observe that mismatch.
Other possible hedging routes include trading VIX futures, offsetting exposure against related ETNs, and using over-the-counter variance swaps if issuance grows enough to support that approach. These are proposed mechanisms, not a verified description of UBS’s actual positions. The discussion also raises issuer credit risk and notes that disclosed holdings were not found by one respondent. Its market-volume and product references are historical, so they should not be treated as current liquidity evidence.
Key ideas
- A proxy hedge can reduce liquidity demands while increasing tracking error.
- S&P 500 options may serve as an imperfect hedge for VIX-linked exposure.
- VIX futures, related ETNs, and variance swaps are discussed as possible hedging tools.
- The answers do not verify UBS’s actual hedge or holdings.
- An ETN also exposes investors to the issuer’s credit risk.
Tags
Full text
# How does UBS hedge its exposure to XVIX ETN? # How does UBS hedge its exposure to XVIX ETN? I am wondering how UBS hedges its exposure to its ETN XVIX. Unless I am grossly overestimating the trading costs, executing the strategy they describe in their prospectus with futures would be quite expensive, especially since they would incur some slippage (back months are not super liquid). Any ideas on how they do it? Do they have some way to reduce the amount of trades they have to execute in order to track the indices they base their strategy on (SP indices)? ## Answer by glyphard (score 6) https://quant.stackexchange.com/a/596 The key in vix based etn's, or any exotic etf/etn in general is the tracking error. Compared to the spot vix (or short spot vix), even considering the long-short term structure features that xvix has, the tracking error is going to be nontrivial. Even leveraged equity basket etfs have terrible tracking error. The exotics are even worse... Just compare a return series over a month or more. A lot of times, even a few days will make the tracking error issue clear. In vix one of the reasons is that there isn't a perfect hedge for them, so traders use S&P500 options as a proxy. This lowers the liquidity burden, but increases the tracking error. ## Answer by bill_080 (score 3) https://quant.stackexchange.com/a/637 I've been looking around for the holdings of this device, and so far I can't find it listed anywhere. I'll keep looking, but unless I find something to the contrary, it looks like UBS is your credit risk (if they go down, this thing goes down). And, remembering Lehman Bros, that possibility is something to think about. ## Answer by jaredwoodard (score 3) https://quant.stackexchange.com/a/4164 XVIX volume today was 11k shares. Back month VIX futures volume is almost 2k contracts in Mar13 and higher from there as you get nearer in time. Given the multiplier in the futures I don't see the problem, esp. now that the back month bid/ask spreads are usually one or two ticks wide. If the ETN product did really take off, UBS could do what Credit Suisse did with TVIX and negotiate OTC variance swaps to hedge their issuance. Until recently, UBS also had a suite of individual month VIX ETNs, which it could have netted against XVIX. They closed those in September.
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