What is Volatility Risk

This study introduces basic concepts about hedging and provides an overview of common hedging practices. This theoretical introduction is followed by an empirical application in which the hedging effectiveness of the VIX ETPs is evaluated. The iPath Series B S&P 500 VIX Short Term Futures ETN (VXX) and the SPDR S&P 500 Trust ETF (SPY) are taken for the empirical application. Dynamic conditional correlations between the VXX and SPY are obtained from DCC-GARCH framework. Based on the estimated conditional volatilities of the SPY and the hedged portfolio, a hedging effectiveness index is constructed. Results show that the hedging effectiveness of the VXX increases in turbulent periods such as the last three months of 2018 marked by the plummeting oil prices, increasing uncertainties about the Brexit deal, and rising federal funds rates and the month of March 2020 when the COVID-19 pandemic became a global concern.