The VIX index is a measure of implied volatility of the S&P-500 index. It was first created in 1993 and uses liquid exchange traded options on the S&P-500 at (or nearest to) 30 day maturity to calculate a precise value for implied volatility. Over the years the VIX has become an important barometer of market activity. It is sometimes known as the “fear index” since high levels of the VIX demonstrate high market volatility and with the expectation of possible large future moves, with the fear that they could be on the downside.
Mainstreaming implied volatility
The notion of “implied” volatility (as opposed to the simpler “historical”) has been well known since the Black Scholes option pricing formula was devised. Some twenty years later (the early 1990s) the idea of “local volatility” models was formulated by Dupire, Derman and others. This significantly extended theory beyond Black Scholes and helped provide a more complete view of pricing and risk management because of the way it combines options of different strikes to provide a two-dimensional view in strike and maturity. Shortcomings in the local volatility framework have since been well documented and today other models such as stochastic volatility are now considered more reliable. However, its contribution remains key and its development provided the inspiration behind the concept of the VIX which was first introduced by the CBOE during that period. The calculation is a little technical and has been applied to many other indices (such as the Nasdaq, EuroStoxx and FTSE-100). It is also calculated for a number of different maturities ranging between 9 days and one year.
In the US at least, just by knowing the level of the S&P-500 and the VIX, traders can get a very good sense of where the market stands and is heading. The highest level recorded by the VIX in the last ten years was 82% in March 2020 during the COVID-19 market shock. This is equivalent to a volatility level normally associated with speculative stocks or troubled companies. By contrast, the lowest value seen over the last ten years is just below 10%, with the long term average around 20%.
In the years since it was created, the VIX has assumed a further importance which was probably not envisaged at the outset. This can be divided into two categories, market predictions and financial instruments.
Market predictive powers
The VIX represents a single measure of implied volatility which is sometimes taken to indicate the markets prediction of future volatility but translating this to concrete advantage is difficult, particularly as volatility is a second order quantity with mean reverting behaviour. A natural question is how much predictive power does the level of the VIX have in estimating future volatility. To test this, we analysed S&P volatility and the VIX since 2007, a substantial time period covering many market cycles. The “R squared” regression number for future realised 30 day volatility against the VIX level is 51%. This compares to 43% when regressing future realised volatility against current historic volatility. Therefore the VIX is slightly better than historic volatility in predicting future volatility. Given that the market can only price in what it sees today it is perhaps unreasonable to expect the VIX to be a stronger predictor of market volatility. The other observation we can make from the same data set is the strong negative correlation between the VIX and the S&P-500. This was measured at -70% over the same period, showing that increase in volatility strongly tends to accompany market declines showing that the VIX’s nickname of the “Fear Index” appears justified. Many trading strategies have been devised to try to extract value from the subtle and changing relationship between the VIX and the market itself.
Different flavours of VIX
This leads onto the second category which is the inevitable proliferation of direct financial instruments such as futures, ETFs and further indices that track the VIX in some way. Examples include the S&P 500 Vix Mid-Term Futures, ProShares Short VIX Short-Term Futures ETF, iPATH S&P 500 VIX Short-Term Futures ETN (source www.structuredretailproducts.com).
Such instruments do not always behave exactly as anticipated for technical reasons. Although the VIX methodology means that a value can be assigned daily or real-time, this does not necessarily mean that translating it into an investable asset is straightforward. Various technical “carry” effects mean that such instruments may not perfectly mirror actual changes in the VIX itself. In this regard it has more in common with commodity indices rather than equity. The calculation of the VIX is derived from the value of options of different strikes and therefore hedging the VIX will in general require using much of the same universe. This can incur costs due to transactions or liquidity.
Further developments have included ETFs linked to leveraged and short versions of the VIX. As with all such extended versions of an index accuracy and governance is key. A recent enforcement from the SEC fined the index calculation agent S&P Dow Jones for publishing stale values of a short VIX future based index during a day of market volatility in February 2018. Given the attention that surrounds indices under the Benchmark Regulation and the pivotal role the VIX now plays in the market there is a lot of responsibility on index providers and ETF issuers.
I expect that the VIX will continue to play an important role in the market and its creation remains one of the most important developments in the financial world in the last thirty years.
A version of this article has also appeared on www.structuredretailproducts.com
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