SHOULD I CARE ABOUT TREASURY VOLATILITY?

We were once asked by a bright but brash young portfolio manager why anyone should care about TYVIX, an index of US Treasury volatility that we helped Chicago Board Options Exchange (CBOE) create. Until then, we had had no difficulty discussing countless intricate applications of the index with sophisticated traders, but we found ourselves unable to articulate an incisive answer to this most basic question.

As it happens too often in finance, we had mistaken our fluency in complex and technical matters for a genuine grasp of underlying economic fundamentals, so we needed to bite the bullet and go back to basics. This site chronicles our humble journey to rebuild our mental model of volatility in fixed income markets from the ground up in the hopes of bringing further depth to the exchange of ideas around TYVIX.

Standardization of financial market volatility

Volatility hasn’t always been so accessible

Besides the small coterie of derivatives wizards who could trade options in their sleep, most investors have traditionally viewed volatility as a nuisance in their portfolio that needs to be minded and, in theory, managed. We say "in theory'' because controlling portfolio volatility is in fact a formidable task, and neither foundational volatility reduction techniques nor third-party products are impervious to all market conditions.  Some historical attempts to rein in volatility have even backfired quite infamously--portfolio insurance in the 1987 crash comes to mind--and the jury's still out on their modern day reincarnates like tail risk funds.

Shifting investor attitudes towards volatility

But if it's all such doom and gloom, why is the market for standardized volatility trading expanding so rapidly? We think it's because a growing number of investors are beginning to recast volatility as an opportunity in and of itself and not just a bane of the traditional investment process, and they're taking direct exposure to volatility for boosting yield and hedging. If you've heard phrases like "volatility as an asset class'' or "volatility as an opportunity class,'' this is probably what they're getting at.

TYVIX adds Treasury volatility to the the growing ecosystem of standardized volatility indexes and derivatives sparked by the success of VIX--CBOE's blockbuster index of S&P 500 volatility--and no dizzying formulas or esoteric theories should be required for investors to take advantage of it.

US Treasuries: "The most important market in the world"

US Treasuries are debt securities issued by the US Department of the Treasury to help finance activities undertaken by the government, such as defense and Social Security, and to fuel economic growth by putting credit to productive use, such as funding research and innovation. Once they begin trading in secondary markets, Treasuries go well beyond their primary role to perform numerous ancillary functions that are critical to the workings of the global financial system. Each of these facets brings about mechanisms through which Treasury volatility reverberates worldwide to affect most investors with varying degrees of subtlety.

A benchmark interest rate for US Dollars

Arguably the most far-reaching ancillary function of the Treasury term structure is to set a baseline for the time value of money used to discount future cash flows. As most financial securities may be valued as a discounted stream of contingent future payments, it stands to reason that changes in the Treasury curve affects practically all securities under the sun, some more obviously than others.

For example, bonds issued by credit-worthy entities, such as companies we all know like IBM and John Deere, are quoted and traded as a spread to duration-matched benchmark Treasury yields. Types of securities affected by the Treasury curve include:

1. Corporate bonds
2. Agency mortgage backed securities
3. Municipal bonds
4. USD-denominated emerging market bonds
5. Treasury Inflation Protected Securities
6. Interest rate-sensitive equities

A tool for monetary policy the world over

When too much borrowed money goes to wasteful consumption or counterproductive investments, and debtors become unable to repay, credit rears its darker side and sparks a deleveraging cycle like the one we experienced after the financial crisis of 2008. In a deleveraging cycle, lenders tighten credit, businesses and individuals spend less, asset prices fall, money drains out of the economy, and economic growth slows down. To manage the double-edged nature of credit, the Federal Reserve Bank (the "Fed'')--an independent but close consort of the Treasury Department--uses Treasuries as a primary tool for controlling the money supply to target inflation and foster growth.

The Fed is not the only central bank to use Treasuries as a key policy tool. Central banks around the world rely on Treasuries as the most common medium for maintaining foreign currency reserves to stabilize the value of their domestic currency as trade imbalances are in constant flux.

A cornerstone of short-term liquidity

A more esoteric yet equally vital ancillary fuNction of Treasuries is to serve as collateral for short-term funding for routine transactions lubricating financial markets.  An ever-changing supply of cash comes from individuals and institutions looking to earn interest on idle cash while maintaining ready access to it, and an equally persistent yet variable demand for cash comes from dealers and investors looking for cheap on-demand leverage to finance securities holdings through transactions such as repos. The key lubricant for matching this fluid supply and demand for cash is a uniquely high-quality, liquid, and standardized collateral: Treasuries.

A safe haven asset

Treasuries have a unique de facto designation as the safe haven asset'' in US markets. This is not an intentional role served by Treasuries; rather, it stems from the historical experience that investors flock to Treasuries as the surest way to preserve capital during market panics when fear and uncertainty reign supreme. This "flight to quality'' phenomenon can lead to peculiar incidences wherein Treasury prices increase with investor risk aversion, which in turn buttresses--somewhat paradoxically--the performance of riskier securities like corporate bonds. This dynamic is likely to be new to those only familiar with equity market volatility.

When Treasuries sneeze, the entire system catches a cold

Pronounced price swings in Treasuries bring a jolt of volatility to an immense amount of related securities and cause strain to the above-mentioned market mechanisms. Such volatility spikes can lead to wide-reaching impact on investors, corporations, and even governments with enormous notional exposures to fixed income asset and liabilities. While Treasury volatility may sound like an oxymoron at first to those accustomed to dealing with the wilder price swings of stocks, the dominant size of fixed income markets and hazards enumerated below should provide ample reason for any investor to realize its importance.

Acute Treasury volatility tends to coincide with ...

1. Drawdowns in fixed income portfolios
2. Amplified volatility in many markets sensitive to the Treasury curve
3. Shortfalls for liability-driven fixed income investors
4. Stress in short-term funding markets
5. Forced liquidation by leveraged investors
6. Pronounced tracking error for benchmarked fixed income portfolios
7. Erosion of investor confidence in central bank actions
8. Increased general uncertainty in the investment environment
9. Difficult funding environment for public and private entities
10. Emotional distress and ruinous investment decisions

Conquering volatility

Source: CBOE

Volatility in financial markets refers to the magnitude of swings in securities prices, and common industry practice defines it as the annualized standard deviation of daily returns over a given period. Interest rate market participants also use a complementary measurement of yield volatility called basis point volatility; however, here we focus on price-return volatility since Treasury derivatives are price-based unlike, say, interest rate swaps.

Origins and nature of volatility

Commonly posited drivers of volatility are anecdotal and endogenous to varying degrees given the difficulty in proving causality, but are nonetheless essential to building intuition around the nature of volatility.

1. Unexpected market-moving news and events
2. Forced deleveraging
3. Poor market liquidity
4. Demand and supply shocks
5. Unpredictable monetary policy
6. Confluence of behavioral forces

The episodic and destabilizing nature of the forces driving volatility punctuates periods of tranquility with sharp and sudden spikes that are commonly followed by a more gradual descent as the market digests the shock, until the next one arrives. This makes the behavior of volatility quite distinct from diversified asset returns such as stocks and bonds, which have a natural upward drift over time as economies grow and companies pay dividends and coupons.

Tracking Treasury volatility with TYVIX

The natural first step towards grasping the potential for using Treasury volatility to one's advantage is to simply start monitoring it. CBOE's VIX index of S&P 500 volatility has in recent years become a mainstay on traders' dashboard of market indicators, and TYVIX is its conceptual analogue for the Treasury market: a transparent benchmark measure of 30-day clean implied volatility of TY that is widely disseminated every 15 seconds.

Clean implied volatility

TYVIX and VIX are both indexes of clean implied volatility extracted from a particular set of options prices, which may be interpreted as the market consensus for volatility to be realized over a future time horizon--30 days in this case--plus a premium. We use the qualifier clean'' to distinguish it from what is commonly known as implied volatility of an individual options contract, which refers to the value of a volatility parameter in a specific options pricing model, which often varies across options with different strikes despites sharing the same maturity, and therefore lacks a coherent economic interpretation. In contrast, clean implied volatility is both model- and strike-independent, and carries an intuitive interpretation as the fair price of volatility.

TYVIX as a market timing indicator

The forward-looking nature of TYVIX could help investors anticipate looming spikes in realized TY volatility and position against the many perils accompanying them.

The index may be used systematically as a market timing indicator for investment objectives such as:

1. asset class rotation
2. security selection
3. drawdown avoidance
4. leverage control

To the extent that many strategists find VIX useful as a market timing indicator for equities, TYVIX is likely to be a useful complementary indicator for bond markets and other market variables sensitive to monetary policy and macroeconomic forces.

Treasury volatility trading with TYVIX futures

Some investors may wish to go a step further and trade Treasury volatility directly to hedge their portfolios or enhance yield. Futures on TYVIX listed at the CBOE Futures Exchange provide a straightforward mechanism for creating directional exposure to clean implied volatility: one simply buys or sells a futures contract to be long or short TYVIX, respectively.

Before the introduction of TYVIX futures, interest rate volatility trading was the rarefied domain of experts versed in bewildering options-based volatility strategies, from which even many institutional bond portfolio managers have shied away. The same could be said of equity volatility trading before VIX derivatives exploded in popularity, which drew a significantly larger user base to get involved through a wide range of applications.

Potential trading applications of TYVIX futures include (but certainly are not limited to!):

1. hedging tail risk & smoothing portfolio returns
• drawdowns in fixed income securities
• systemic liquidity risk
• deleveraging and fire sales
• increase in tracking error
2. tactical hedging of volatility-sensitive securities
• mortgage-backed securities
• callable bonds
• interest rate options
3. expressing macroeconomic views