TVIX Tracking Error to Its IV Price

In March 2012 Credit Suisse announced that they would resume limited share creation, but TVIX is still not accurately tracking its indicative value (IV).  An April 11, 2012 intra-day quote gave TVIX’s bid at 9.39 while its IV on Yahoo Finance (symbol ^TVIX-IV) was 8.21—a 6.4% difference.   By comparison ProShares’ UVXY, which has the same performance goals as TVIX was at 20.30, with an IV of 20.25— a 0.25% difference.

This is not good.

If things were working well, authorized participants (APs) would be able to short TVIX, walk over to Credit Suisse’s doorstep, purchase TVIX shares at the IV price to cover their short, and pocket a cool $1.18 per share with no risk. They would if they could.

So where is the problem?   Are there no shares available to short?   I doubt it, although I think TVIX shares were exceeding hard to borrow right before Credit Suisse made their limited creation announcement March 22nd.

I suspect the problem is on the share creation side.  Credit Suisse can require the APs to supply swaps instead of cash as part of the share creation process—likely with challenging conditions.   In their press release Credit Suisse takes carte blanche in their ability to specify the deliverables:

“..will be on terms acceptable to Credit Suisse, including the counterparty meeting Credit Suisse’s creditworthiness requirements, margin requirements, minimum size and duration requirements and such other terms as Credit Suisse deems appropriate in its sole discretion.”

If these terms are onerous enough to create a significant premium on the appropriate swaps then TVIX’s price behavior starts to make sense.  The chart below shows the recent relationship between TVIX’s market price and its indicative value.

If expensive swaps are the problem this chart suggests TVIX’s premium will top out in the 5% to 10% range when TVIX is flat or declining.   If volatility is climbing then the premium will drop, and never go very far negative because the share redemption process is still working well.  Credit Suisse is happy to give the APs cash at the IV price in exchange for TVIX shares…