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What Does the VIX Really Tell Us?
Traders Magazine Online News, April 12, 2018
A lot has been made of the recent spike in the VIX, which in February jumped from single-digit levels to nearly 50% following a prolonged period of low volatility. Now that “volatility is back”, we thought it would be a good time to examine what exactly the VIX measures are and how to interpret them.
Implied volatility
Implied volatility, the heart of the VIX, is often described as an ex-ante (forward-looking) measure of risk precisely because it does not rely on historical data. Before the advent of the Black-Scholes pricing formula, volatility was only measured using historical returns. Historical volatilities measure market price movements that already happened rather than anticipating what volatilities may lie ahead. Measuring historical volatility provides a number that represents the middle of the historical window: a 60-day volatility is correct, on average, about 30 days ago. It leaves completely unanswered the question of current market volatility. These ex-post volatility measures are appropriate for understanding historical dynamics but are less suitable for forward-looking purposes like hedging or asset allocation.
The VIX was introduced to provide a forward-looking estimate of equity volatility. The Black-Scholes model, used in the traditional way, provides an estimate of the fair-market price for options based on a number of inputs including the SPX ex-post volatility computed from historical prices. The formula can be used “backwards” – instead of computing the price of the option using the volatility, you can use the market price of the option to compute the volatility that matches the observed market price. That volatility is “implied” by the model: it’s the only volatility consistent with the market-observed prices. In this way, the VIX is calculated using information about current market conditions.
The VIX itself is computed from SPX call and put options expiring about 30 days ahead, and so represents the current market’s best guess of what the volatility will be in 30 days. It is “forward-looking” in that we assume market participants have priced short-term options consistent with an expectation that the future volatility will be the value implied through the Black-Scholes equation.
How forward-looking is it, really?
Consider for a moment the case of equities pricing via the discounted cash flow analysis method: a case can be made that a stock’s price is simply the market’s reflection of the discounted expected future cash flows. However, the computation relies on predictions about uncertain future cash flows and a discount rate to calculate their net present value. Real-life divergences from assumptions underpinning the analysis cause equity prices that can be quite different from what we calculate. In addition, the cash flows themselves do not depend on the implied stock price. It is in the same way that future volatility is not dependent on the market’s implied volatility.
VIX’s prediction of volatility
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