A short position in TVIX provides several ways to win.
Since Credit Suisse stopped creating new TVIX units last week, the price has only partially reflected changes in the underlying intrinsic value of the TVIX ETN. The current price of TVIX of $16.29 is nearly 20% greater than its intrinsic value of $13.60. Since Credit Suisse indicated that it had “temporarily suspended issuance of new TVIX units because of internal limits on the size of the ETNs”, I believe Credit Suisse intends to resume issuance once they are able to figure out how to hedge the substantial increase in exposure to volatility that resulted from a rapid increase in the amount of TVIX outstanding. Since TVIX is structured as an Exchange Traded Note (ETN) rather than as an ETF, Credit Suisse is on the hook for the value of the ETNs. The value of TVIX outstanding had quadrupled from the end of December to nearly $700 million on February 21, when Credit Suisse suspended issuance.
The underlying unlevered ETN, the VXX, loses value over time because the VIX index is usually in contango, which means that the near month volatility futures generally trade cheaper than the next month. The VXX is designed to maintain a constant 30 day weighted average maturity. This is accomplished by “rolling” a portion of the near month position into the next month. The intrinsic value of the VXX on March 1 was based 50% on the March CBOE VIX futures and 50% on the April contract. Each day 5% of the notional value of the ETN is shifted from the near month to the next month. Since the March futures are trading at 20.15 and the April futures are at 23.37, the ETN loses a bit of value every day from this reallocation. (Each 100 units of March futures at 20.05 converts into approximately 86 units of the April futures at 23.30.) The VXX ETNs was written up as a short on VIC in 2010. The write-ups on VXX and the related comments are a good starting point for research.
Levered ETNs such as TVIX are likely to lose even more value over time than their unlevered counterparts. This is due to simple mathematics. If the index goes nowhere, let’s say from 20 to 25 and back to 20, an unlevered ETN would go up 25% and then down 20%, and would finish flat. (125% times 80% =100%) A 2X levered ETN would go up 50% and down 40%, and would finish down 10%. (150% times 60% = 90%) Note that the actual daily moves in the VXX will be less extreme than the example above. The same principle will apply over time and will result in long term erosion in the value of TVIX.
Last year’s performance of the VIX, VXX and TVIX illustrate the forces that are at work on these products. In 2010, the VIX rose 32%, the VXX fell 5.5% and TVIX fell 50.6%.
Risks
TVIX is designed to be volatile. Last summer when the VIX went from ~14 to 48, TVIX went from ~$16 to $110.
Volatility as measured by the VIX is currently at a relatively low level, particularly in light of the current situation in Europe. VIX is currently around 17. Last year it averaged 24.2, and in 2010 it averaged 22.55. Since 1990, VIX has averaged 20.6. An increase in VIX would increase the value of VXX, and would sharply increase the intrinsic value of TVIX.
To some extent this volatility risk can be hedged out, either through a long position in VXX (the unlevered version of TVIX), VXX calls, or volatility futures. I have not found a good way to hedge the premium to intrinsic value that represents over 15% of TVIX’s market value, and since Credit Suisse has stopped issuing units at “par”, there is a real risk that the premium widens, rather than dissipates.
If the volatility curve shifts from contango to backwardation (near month futures are more valuable than the next month), the intrinsic value will increase over time rather than erode. Historically, the volatility curve is in contango about 70% of the time.
A short squeeze is a possibility, since the market cap of TVIX is less than $700 million.
If Credit Suisse resumes issuing new TVIX units, the 20% premium should evaporate. Unfortunately, I have no idea when, or if, this will happen. Credit Suisse indicated that it had “temporarily suspended issuance of new TVIX units because of internal limits on the size of the ETNs”. The rapid increase in demand for the TVIX exceeded Credit Suisse’s ability to hedge its exposure.
Absent a catalyst, the intrinsic value of the TVIX should fall over time (although with some very uncomfortable spikes) as long as the volatility curve stays in contango and the normal daily fluctuations in the VXX combined with the 2X leverage feature continue to erode value.