[BUBUIOC INC.] VIX - The Chicago Board Options Exchange Volatility Index

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VIX - The Chicago Board Options Exchange Volatility Index &

The VIX vs. S&P 500 Inverse Correlation

In 1993, the Chicago Board Options Exchange (CBOE) introduced the CBOE Volatility Index, VIX, which was originally designed to measure the market’s expectation of 30- day volatility implied by at-the-money S&P 100 Index (OEX) option prices. VIX soon became the premier benchmark for U.S. stock market volatility. It is regularly featured in the Wall Street Journal, Barron’s and other leading financial publications, as well as business news shows on CNBC, Bloomberg TV, CNN/Money, and many other prominent financial institutions. VIX is often referred to as the “fear index.” However, a high VIX is not necessarily bearish for stocks. Instead, the VIX is a measure of market perceived volatility in either direction, including to the upside. (cboe.com)

Ten years later in 2003, CBOE updated the VIX to reflect a new way to measure expected volatility, one that continues to be widely used by financial theorists, risk managers and volatility traders alike.

The new VIX is based on the S&P 500 Index (SPXSM), the core index for U.S. equities, and estimates expected volatility by averaging the weighted prices of SPX puts and calls over a wide range of strike prices. By supplying a script for replicating volatility exposure with a portfolio of SPX options, this new methodology transformed VIX from an abstract concept into a practical standard for trading and hedging volatility.

 

Stock indexes, such as the S&P 500, are calculated using the prices of their component stocks. Like conventional indexes, VIX employs rules for selecting component options and a formula to calculate index values.

VIX is a volatility index comprised of options rather than stocks, with the price of each option reflecting the market’s expectation of future volatility. VIX is an up-to-the-minute market estimate of expected volatility. VIX uses nearby and second nearby options with at least 8 days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index. (cboe.com) “Near-term” options must have at least one week to expiration; a requirement intended to minimize pricing anomalies that might occur close to expiration. When the near-term options have less than a week to expiration, VIX “rolls” to the second and third SPX contract months.

The CBOE VIX formula used today is:

Source:cboe.com

The VIX is calculated as the square root of the par variance swap rate for a 30-day term initiated today. VIX is the volatility of a variance swap and not that of a volatility swap, volatility being the square root of variance, or standard deviation. A variance swap can be perfectly statically replicated through vanilla puts and calls whereas a volatility swap requires dynamic hedging. (Whaley, Robert) The VIX is the square root of the risk neutral expectation of the S&P 500 variance over the next 30 calendar days. The VIX is quoted as an annualized standard deviation.

The price of call and put options can be used to calculate implied volatility, because volatility is one of the factors used to calculate the value of these options. Higher or lower volatility of the underlying security makes an option more or less valuable, because there is a greater or smaller probability that the option will expire in the money. Thus, a higher option price implies greater volatility, other things being equal.

The VIX is quoted in percentage points and can be interpreted as the expected movement in the S&P 500 index over the next 30-day period, which is then annualized. For example, if the VIX is 15, this represents an expected annualized change of 15% over the next 30 days; thus one can infer that the index option markets expect the S&P 500 to move up or down 15%/√12 = 4.33% over the next 30-day period. (Moran, Matthew)

Despite their sophisticated composition, critics claim the predictive power of most volatility forecasting models is similar to that of plain-vanilla measures, such as simple past volatility. (Cumby, R) See chart below:

Performance of VIX (left) compared to past volatility (right) as 30-day volatility predictors, for the period of Jan 1990-Sep 2009. Volatility is measured as the standard deviation of S&P500 one-day returns over a month's period. The blue lines indicate linear regressions, resulting in the correlation coefficients r shown. Note that VIX has virtually the same predictive power as past volatility, insofar as the shown correlation coefficients are nearly identical. (Jorion, P.) Despite criticism, the VIX remains to be the leading Volatility indicator to date used by the majority of financial professionals.

On March 24, 2004, CBOE introduced the first exchange-traded VIX futures contract on its new, all-electronic CBOE Futures ExchangeSM (CFE). Two years later in February 2006, CBOE launched VIX options, the most successful new product in Exchange history. (cboe.com) In less than five years, the combined trading activity in VIX options and futures has grown to more than 100,000 contracts per day. The simplest way to understand VIX options is to think of trading “Volatility” (options) based on “Volatility” (VIX) that is also derived from the “Volatility” of S&P 500 options (this can get rather mindboggling).

VIX is especially valuable to investors since it is based on over 20 years of historical prices. Thus, the extensive data set provides investors with a useful perspective of how option prices have behaved in response to a variety of market conditions. (M. Grant)

The negative correlation of volatility to stock market returns is well documented and suggests a diversification benefit to including volatility in an investment portfolio. VIX futures and options are designed to deliver pure volatility exposure in a single, efficient package available to all interested investors. (Edward Szado)

Conditional Correlation Between VIX and SPX March 2006 to Dec. 2008, CBOE

The increased correlations among diverse asset classes in the latter half of 2008 generated significant losses for many investors who had previously considered themselves well diversified. It is clear from the results of the analysis that, while a passive long volatility exposure may result in negative returns in the long term, it may provide significant protection in downturns. In particular, investable VIX products could have been used to provide some much needed diversification during the 2008 financial crisis. (Edward Szado)

Volatility can be a very important factor in deciding what kind of investment choices an investor will make. Volatility shows the investor the range that a financial instrument has fluctuated in a certain period and thus can be utilized in attempting to predict/anticipate future fluctuations in either direction. Even though VIX is a relatively new tool available to investors, and "Past Results Do Not Guarantee Future Performance." VIX remains today as the leading indicator of expected market volatility used by investors of all over the world. 

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Posted By BUBUIOC INC. to BUBUIOC INC. at 12/06/2012 05:12:00 PM

[BUBUIOC INC.]

In 1993, the Chicago Board Options Exchange (CBOE) introduced the CBOE Volatility Index, VIX, which was originally designed to measure the market’s expectation of 30- day volatility implied by at-the-money S&P 100 Index (OEX) option prices. VIX soon became the premier benchmark for U.S. stock market volatility. It is regularly featured in the Wall Street Journal, Barron’s and other leading financial publications, as well as business news shows on CNBC, Bloomberg TV, CNN/Money, and many other prominent financial institutions. VIX is often referred to as the “fear index.” However, a high VIX is not necessarily bearish for stocks. Instead, the VIX is a measure of market perceived volatility in either direction, including to the upside. (cboe.com)

Ten years later in 2003, CBOE updated the VIX to reflect a new way to measure expected volatility, one that continues to be widely used by financial theorists, risk managers and volatility traders alike.

The new VIX is based on the S&P 500 Index (SPXSM), the core index for U.S. equities, and estimates expected volatility by averaging the weighted prices of SPX puts and calls over a wide range of strike prices. By supplying a script for replicating volatility exposure with a portfolio of SPX options, this new methodology transformed VIX from an abstract concept into a practical standard for trading and hedging volatility.

Stock indexes, such as the S&P 500, are calculated using the prices of their component stocks. Like conventional indexes, VIX employs rules for selecting component options and a formula to calculate index values.

VIX is a volatility index comprised of options rather than stocks, with the price of each option reflecting the market’s expectation of future volatility. VIX is an up-to-the-minute market estimate of expected volatility. VIX uses nearby and second nearby options with at least 8 days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index. (cboe.com) “Near-term” options must have at least one week to expiration; a requirement intended to minimize pricing anomalies that might occur close to expiration. When the near-term options have less than a week to expiration, VIX “rolls” to the second and third SPX contract months.

The VIX is calculated as the square root of the par variance swap rate for a 30-day term initiated today. VIX is the volatility of a variance swap and not that of a volatility swap, volatility being the square root of variance, or standard deviation. A variance swap can be perfectly statically replicated through vanilla puts and calls whereas a volatility swap requires dynamic hedging. (Whaley, Robert) The VIX is the square root of the risk neutral expectation of the S&P 500 variance over the next 30 calendar days. The VIX is quoted as an annualized standard deviation.

The price of call and put options can be used to calculate implied volatility, because volatility is one of the factors used to calculate the value of these options. Higher or lower volatility of the underlying security makes an option more or less valuable, because there is a greater or smaller probability that the option will expire in the money. Thus, a higher option price implies greater volatility, other things being equal.

The VIX is quoted in percentage points and can be interpreted as the expected movement in the S&P 500 index over the next 30-day period, which is then annualized. For example, if the VIX is 15, this represents an expected annualized change of 15% over the next 30 days; thus one can infer that the index option markets expect the S&P 500 to move up or down 15%/√12 = 4.33% over the next 30-day period. (Moran, Matthew)

Despite their sophisticated composition, critics claim the predictive power of most volatility forecasting models is similar to that of plain-vanilla measures, such as simple past volatility. 

Volatility is measured as the standard deviation of S&P500 one-day returns over a month's period. The blue lines indicate linear regressions, resulting in the correlation coefficients r shown. Note that VIX has virtually the same predictive power as past volatility, insofar as the shown correlation coefficients are nearly identical. (Jorion, P.) Despite criticism, the VIX remains to be the leading Volatility indicator to date used by the majority of financial professionals.

On March 24, 2004, CBOE introduced the first exchange-traded VIX futures contract on its new, all-electronic CBOE Futures ExchangeSM (CFE). Two years later in February 2006, CBOE launched VIX options, the most successful new product in Exchange history. (cboe.com) In less than five years, the combined trading activity in VIX options and futures has grown to more than 100,000 contracts per day. The simplest way to understand VIX options is to think of trading “Volatility” (options) based on “Volatility” (VIX) that is also derived from the “Volatility” of S&P 500 options (this can get rather mindboggling).

VIX is especially valuable to investors since it is based on over 20 years of historical prices. Thus, the extensive data set provides investors with a useful perspective of how option prices have behaved in response to a variety of market conditions. (M. Grant)

The negative correlation of volatility to stock market returns is well documented and suggests a diversification benefit to including volatility in an investment portfolio. VIX futures and options are designed to deliver pure volatility exposure in a single, efficient package available to all interested investors. (Edward Szado)

The increased correlations among diverse asset classes in the latter half of 2008 generated significant losses for many investors who had previously considered themselves well diversified. It is clear from the results of the analysis that, while a passive long volatility exposure may result in negative returns in the long term, it may provide significant protection in downturns. In particular, investable VIX products could have been used to provide some much needed diversification during the 2008 financial crisis. (Edward Szado)

Volatility can be a very important factor in deciding what kind of investment choices an investor will make. Volatility shows the investor the range that a financial instrument has fluctuated in a certain period and thus can be utilized in attempting to predict/anticipate future fluctuations in either direction. Even though VIX is a relatively new tool available to investors, and "Past Results Do Not Guarantee Future Performance." VIX remains today as the leading indicator of expected market volatility used by investors of all over the world.

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Posted By BUBUIOC INC. to BUBUIOC INC. at 12/11/2012 11:30:00 AM