Lesson 16 of 25 · 7 min
An inverse volatility product, February 2018: termination by its own terms
Some losses are not market judgments; they are clauses, executed exactly as written, on schedule.
An exchange-traded note trading under the ticker XIV was designed to deliver the inverse of the daily return of an index of short-dated volatility futures. Two features of that design decided what happened on 5 February 2018, and both were printed in the offering documents before anyone bought a single unit.
The first is the daily reset. Delivering minus one times a daily return requires the exposure to be rebalanced every day, which means that when the tracked index rises, the product must increase its volatility exposure — buying into the rise, in size, at the close, insensitive to price. Every product with the same design does it at the same moment, so the demand is simultaneous rather than staggered.
The second is the acceleration clause. The terms permitted the issuer to redeem the note early if its intraday indicative value fell more than eighty percent from the prior closing level. On 5 February 2018 the volatility index and its futures rose sharply late in the session. The indicative value fell through that threshold, the acceleration was exercised, and the note was redeemed at a value reported at around four dollars against a prior close near ninety-nine dollars.
The holder's loss was not a mark that might recover. It was a termination, which converts a position into a final cash amount at the worst observed point. A daily inverse product also has a second arithmetic feature worth stating: recovering from a ninety-six percent fall requires a twenty-five-fold gain, so the path dependence is not symmetrical.
Read the termination clause before the strategy. A strategy has a distribution of outcomes; a clause has a trigger, and the trigger fires at the worst moment by construction.
Key terms
- Daily reset
- Rebalancing exposure each day so the stated multiple applies to one day's return. It forces buying into rises and selling into falls, mechanically.
- Acceleration event
- A contractual trigger allowing an issuer to redeem a note early at a stated value. It converts a paper loss into a settled one.
- Indicative value
- The intraday computed value of a note, as distinct from its market price. Acceleration clauses are typically written against this figure.
Worked example
Two days of a daily inverse product
Illustrative figures scaled down so the arithmetic is followable; they are not the reported amounts. A note starting at 100.00, delivering minus one times the daily return of its index, with acceleration permitted below 80 percent of the prior close.
- Day one: index rises 11 percent
- 89.00
- Acceleration threshold for day two
- 17.80
- Day two: index rises 92 percent
- 7.12
- Cumulative loss
- 92.88%
- Gain required to return to 100.00
- 14.04x
100.00 × (1 − 0.11).
89.00 × 0.20.
89.00 × (1 − 0.92), below the threshold.
(100.00 − 7.12) ÷ 100.00.
100.00 ÷ 7.12.
The second day did not merely lose money; it crossed a contractual line, which ended the position at 7.12 rather than leaving it to recover.
Check yourself
A daily inverse note closes at 62.40. The next day its index rises 88 percent, and the terms permit acceleration below 80 percent of the prior close. What is the value, and is the clause triggered?
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.