Risk Management

Page 1 of 3

Volatility and the Skunk Many investors interpret the current level of the CBOE Volatility Index (VIX) as a danger signal, with the equity markets at new highs, price/earnings multiples at decade highs, high economic policy uncertainty, and rising geopolitical tensions.

Volatility and the Skunk

Volatility and the Skunk

By Eben Maré, Head: Fixed Income at Absa Asset Management and Associate Professor, University of Pretoria

“What kills a skunk is the publicity it gives itself” – Abraham Lincoln


Investors typically equate volatility (or more technically the standard deviation of asset returns) with risk. In this regard, the CBOE Volatility Index, better known as the VIX, has become a well-known gauge of an investor’s risk appetite or fear. 

The VIX is calculated on the basis of a range of options priced on the S&P500 equity index. The index offers an indication of the 30-day volatility implied by the options market (referred to as implied volatility). 

There are a great many uses for the VIX. Investors base asset allocation decisions on the VIX and try to determine universal relationships between currencies, fixed income assets, and equity markets based on movements in the VIX. 

Figure 1 shows the evolution of the VIX over time – notable is the current levels at multi-year lows. Many investors interpret this fact as a danger signal. Is that correct? Let’s investigate.

 

Figure 1: VIX (2004 to date)

Figure 1: VIX (2004 to date)


From Figure 1 we note that VIX ranges between about 10% and 80%, over the period starting 2004 to date. A conventional interpretation would be that VIX should revert to its mean level … 

Figure 2 demonstrates that VIX can be broken into different regimes – in this analysis we demonstrate two regimes entailing low volatility and high volatility periods. In this interpretation, we enter a period of low volatility or high volatility and exit those regimes probabilistically. The fact that VIX is at multi-year lows therefore carries little forecasting relevance. In essence, volatility is low for possible structural reasons (which we will examine below), we should examine risk on the basis of reasons that could create higher market volatility. (For completeness, the regimes are identified using a Markovian regime switching model.)

 

Figure 2: VIX and volatility regimes

Figure 2: VIX and volatility regimes

 

Next Page   2 3 

Save PDFs of your favorite articles, authors and companies. Bookmark this article, or add to a list of your favorites within mytmi.

Discover the benefits of myTMI

 Download this article for free