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I am wondering how UBS hedges its exposure to its ETN XVIX. Unless I am grossly overestimating the trading costs, executing the strategy they describe in their prospectus with futures would be quite expensive, especially since they would incur some slippage (back months are not super liquid).

Any ideas on how they do it? Do they have some way to reduce the amount of trades they have to execute in order to track the indices they base their strategy on (SP indices)?

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3 Answers 3

XVIX volume today was 11k shares. Back month VIX futures volume is almost 2k contracts in Mar13 and higher from there as you get nearer in time. Given the multiplier in the futures I don't see the problem, esp. now that the back month bid/ask spreads are usually one or two ticks wide.

If the ETN product did really take off, UBS could do what Credit Suisse did with TVIX and negotiate OTC variance swaps to hedge their issuance.

Until recently, UBS also had a suite of individual month VIX ETNs, which it could have netted against XVIX. They closed those in September.

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The key in vix based etn's, or any exotic etf/etn in general is the tracking error.

Compared to the spot vix (or short spot vix), even considering the long-short term structure features that xvix has, the tracking error is going to be nontrivial.

Even leveraged equity basket etfs have terrible tracking error. The exotics are even worse...

Just compare a return series over a month or more. A lot of times, even a few days will make the tracking error issue clear.

In vix one of the reasons is that there isn't a perfect hedge for them, so traders use S&P500 options as a proxy. This lowers the liquidity burden, but increases the tracking error.

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I am pretty sure your answer is incorrect. There is virtually no tracking error for this type of security. It's an ETN, not an ETF. Therefore, they guarantee you the value of the index (minus fees) if you choose to redeem the note. I know that replicating the strategy is very expensive, that's why I wonder how they could hedge themselves in their own book. If you read the prospectus, you will see how the payout is determined. –  BobJones Feb 23 '11 at 22:08
    
it still has tracking error. look at the daily return series. (not enormous, but it is present). Wait till vix gets really high like into the 30's, you'll likely see the tracking error increase. –  glyphard Feb 23 '11 at 23:10
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Isn't this "tracking error" just due to trading? If you read the prospectus, they state that there is no tracking error. It is not how this type of security is designed. It's a debt security wherein the issuer promises to pay the value of the index minus mgmt fee (85bps/year). –  BobJones Feb 24 '11 at 14:17
    
XVIX tracks a spread in VIX futures prices. Any tracking 'error' attributable to the futures prices not matching spot VIX should not be attributed to XVIX failing to track... –  shabbychef Apr 13 '11 at 19:24

I've been looking around for the holdings of this device, and so far I can't find it listed anywhere. I'll keep looking, but unless I find something to the contrary, it looks like UBS is your credit risk (if they go down, this thing goes down). And, remembering Lehman Bros, that possibility is something to think about.

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It's an ETN, not an ETF. they do not have to publish holdings. –  shabbychef Apr 13 '11 at 19:22

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