"Volatility as the new Black-Scholes" (VIX; VXX; CVOL)

A sharp bit of writing and a nice find, from FT AlphavilleL

Here’s a timely discussion as the Vix smashes through the 20 level.
It comes via Euromoney columnist, Theo Casey, and it concerns a 2010 paper by Eckhard Platen, professor of quant finance at the University of Technology, Sydney.

In it, the Platen argues that volatility derivatives may be the source of the next systemic crisis. Basically, portfolio hedgers use these instruments — stuff like the CBOE’s Vix — to hedge against the risks of falling equity markets.

The counterparties are banks, which means they’re on the hook to pay out when volatility rises. And much of their collateral used by banks to sell volatility protection, Platen says, happens to be equity. Which means their assets might be in freefall, right when they’re expected to make good on equity-loss protection contracts.
Downward spiral, much?

Anyway, Casey is a derivatives wonder boy so it’s worth listening to his take:

…Canvassing the views of other commentators, academics and practitioners, I find that on balance the industry takes a dim view of the professor’s idea. The critique centres on one key aspect of the paper… size.

“This market is simply not big enough to bring the economy to its knees as securitised loans did,” says Jeremy Wien, head of Vix trading at Peak6 Capital Management in Chicago. “The total notional value of those derivatives was in the trillions of dollars. If the global variance swap market across all products were $100bn, I would be surprised.”

Wien may have a point. The Bank for International Settlements’ figures are not much help. The notional amount outstanding of OTC equity-linked derivatives totalled $6.6tr in December 2009. But this lofty figure includes volatility derivatives as well as a much wider pool of non-volatility products …

So it’s a small market, yes....MORE