As tail risks have fallen aside and markets have normalized over the last several years, most of the strange market phenomena from the financial crisis have reversed themselves. Housing prices have firmed up as supply tightens, lending standards have relaxed, and correlations among dissimilar assets have fallen back toward historical norms.
One aspect of the market that has not yet normalized is the relationship between short- and longer-dated option premiums. Near term option implied volatility has fallen to levels in line with realized stock volatility, but further-dated IV is still bid at a higher premium than we would expect. The chart at fig. 1 compares the term structure of VIX futures in 2007 and as of January 18, 2013.
Fig. 1. VIX futures term structure, 2007 & 2013. Source: Goldman Sachs
Two things stand out here.
- The nominal level of the middle and back ends of the curve in January are still quite high. We can speculate about likely causes for greater risk aversion for the later part of the year, but whatever risk scenarios investors have in mind, they are keeping back months well-bid.
- The term structure is still steep. The average term structure for months 1-7 in 2007 was less than two points, and as the chart shows, even at the VIX low for the year, the curve was 3.5 points wide. Compare the gap of 5.1 points in January between the 1st and 7th contracts.
Fig. 2. VIX futures term structure, 02/08/2013. Source: CFE, Condor Options
In the last several weeks, conditions have moderated a little more, and at the close last week the term structure was down to 4.8 volatility points (fig. 2), but with the cash VIX below 13 we are still nowhere near the average term structure levels seen before the crisis.
It may be that the psychological effects of the crisis will keep investors hedged (or over-hedged) for a long time to come. If investor risk aversion does moderate, profits will accrue not to the high-beta volatility sellers at the front part of the curve as much as to those who short the middle and back months; in the mean time, a steep term structure carries well.
Disclosure: Positions in VIX futures and options