What are the goals of a "tradable settlement?"
The VIX Index settlement process is patterned after the process used to settle A.M.-settled S&P 500 Index options. On the days SPX options expire, S&P calculates a Special Opening Quotation (SOQ) of the S&P 500 Index using the opening prices of the component stocks in their primary markets. Traders can replicate the exposure of their expiring SPX options by entering orders to buy and sell the component stocks of the S&P 500 Index at their opening prices. If they are successful, traders can effectively construct a portfolio that matches the value of the SOQ. At this point, the derivatives and cash markets converge.
In a very similar way, the final settlement value for VIX derivatives is a Special Opening Quotation of the VIX Index calculated using the opening prices of SPX options that expire 30 days later. Analogous to the settlement process for SPX options, traders can replicate the exposure of their expiring VIX derivatives by entering buy and sell orders in constituent SPX options. If they are successful, traders can effectively construct a portfolio of SPX options that matches the value of the VIX Index SOQ. By doing so, market participants may make or take delivery of the SPX options that will be used to settle VIX derivatives.
Dual Goals: Replication & Convergence
A tradable settlement creates the opportunity to convert the exposure of an expiring VIX derivative into the portfolio of SPX options that will be used to settle the expiring contract. Specifically, some market participants may desire to maintain the vega, or volatility, risk exposure of expiring VIX derivatives. Since VIX derivatives expire 30 days prior to the SPX options used to calculate their settlement value, a market participant may have a vega risk from its portfolio of index positions that the participant wants to continue to hedge after the participant's VIX derivatives expire.
To continue that vega coverage post expiration for a VIX derivative, a market participant may determine to trade the portfolio of SPX options used to settle an expiring VIX derivative, since those SPX options still have 30 more days to expiration. This trade essentially replaces the uncovered vega exposure "hole" created by an expiring VIX derivative.
Since the VIX Index settlement value converges with the portfolio of SPX options used to calculate the settlement value of VIX derivatives, trading this SPX option portfolio mitigates settlement risk. This is because, if done properly, the vega exposure obtained in the SPX option portfolio will replicate the vega exposure of the expiring VIX derivative (i.e., elimination of slippage). Further, because a market participant is converting vega exposure from one instrument (expiring VIX derivative) to another (portfolio of SPX options expiring in 30 days), the market participant is likely to be indifferent to the settlement price received for the expiring VIX derivative.
Importantly, purchasing the next VIX derivative expiration (i.e., rolling) will not accomplish the conversion of vega exposure since that VIX derivative contract would necessarily cover a different period of implied volatility and is based on an entirely different portfolio of SPX options.
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