RiskTech Forum

EDHEC: The Local Volatility Factor for Asian Stock Markets

Posted: 24 September 2013  |  Source: EDHEC   |  Source: EDHEC

Industry surveys indicate growing investments in Asian passive investment equity products commonly motivated by the expected economic growth of the region relative to the rest of the world and the resulting equity premium. Investors are typically interested more in regional and country cap-weighted indices and ETFs tracking such indices rather than sector or style indices (see Amenc et al. (2012).

On the other hand, investors and asset managers increasingly use OTC or exchange-traded volatility derivatives using volatility indices as underlyings to alleviate losses during market downturns, based on the negative correlation between equity returns and volatility which has been well-documented in the academic literature. From an investor perspective, the negative correlation presents hedging and diversification opportunities. In addition, negative correlation and high volatility are particularly pronounced in stock market downturns, offering protection against stock market losses when it is most needed and when other forms of diversification do not provide
very effective exposure.

Although the market for volatility derivatives in Asia is still immature, it has been slowly developing. Hong Kong and Japan launched implied volatility futures contracts in 2012 and Australia and Korea have revealed plans to launch such contracts in the near future. However, given that US VIX is the most popular implied volatility index with VIX futures easily available, an important question is whether an exposure to a local modelfree option-implied (MFOI) volatility indicator has better hedging properties than an exposure to US VIX. On one hand, the academic literature finds empirical support for the presence of local volatility factors in Asian equity markets implying that investors would be better off with an exposure to a local MFOI volatility index. On the other hand, there is also evidence of spillover effects from the US to the Asian markets suggesting that in times of market turbulence an exposure to VIX can reduce risk.

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