In the realm of investing, the CBOE Volatility Index (VIX) emerged in the 1990s as a revolutionary tool to anticipate market risk. With a unique approach that relies on 30-day options of the S&P 500 Index, the VIX provides a glimpse into traders’ expectations of future volatility in the equities market.
But the real question lies in the accuracy and reliability of this measure. To unravel this mystery, we delved into a deep analysis comparing VIX data dating back to 1990 to the realized volatility of the S&P 500 Index. What we uncovered is a story of intriguing discrepancies and revealing insights.
- Exhibit 1 – The Story of the Data: A snapshot of the complete time series data unveils a consistent trend where the VIX consistently overshoots realized volatility over time. Although there were instances of market mayhem leading to deviations in the pattern, the overall narrative remained intact.
- Exhibit 2 – Crunching the Numbers: Over a 35-year period, S&P 500 Index realized volatility averaged at 15.50%, while the VIX estimated a forward 30-day volatility at 19.59%. This 4.09% spread signals an insurance premium investors pay to mitigate expected volatility, painting a compelling risk picture.
Venturing into a serene period from 1990 to 1996, Exhibit 3 showcases a world devoid of major crises where the VIX consistently overestimated realized volatility by a margin of five to seven percentage points.
The narrative changes drastically in Exhibit 4, which sheds light on the tumultuous 2008 global financial crisis (GFC). A dance of numbers reveals a slow VIX reaction to surging volatility in mid-2008, eventually catching up by late 2008. However, the VIX’s persistence in surpassing realized volatility into early 2009 hints at a market dynamic vulnerable to panics.
The 2020 COVID era echoes similar sentiments in Exhibit 5, where the VIX portrays a delayed response to escalating volatility, once again highlighting the market’s inclination towards overreaction.
Unveiling two pivotal takeaways from the exhibits, we learn that investors pay a steady 4% premium for volatility protection and witness the market’s consistent behavior in times of turmoil. For those venturing into VIX futures and derivatives as a shield against catastrophic events, these findings underscore the premium paid for tail risk insurance and the risks posed by market hysteria.
In essence, the VIX acts as a mirror reflecting the market’s ebb and flow, cautioning investors of the price of protection and the perils of panic-induced overreactions. A nuanced understanding of VIX dynamics can arm investors with strategic insights for navigating the volatile terrains of the financial landscape.
As you embark on your investment journey, remember that knowledge is your greatest ally. Stay informed, stay vigilant, and above all, stay enterprising.
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And as always, remember that these are personal opinions and not financial advice. The views expressed do not necessarily reflect the opinions of CFA Institute or the author’s employer.
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