The Econophysics Blog

This blog is dedicated to exploring the application of quantiative tools from mathematics, physics, and other natural sciences to issues in finance, economics, and the social sciences. The focus of this blog will be on tools, methodology, and logic. This blog will also occasionally delve into philosophical issues surrounding quantitative finance and quantitative social science.

Tuesday, June 13, 2006

VIX and the Recent Market Downturn

When I started this blog, I vowed to myself that I would try to avoid writing about the daily fluctuations of the markets. Why? There are a variety of good reasons for trying not to be too focused on day-to-day market movements (trying to avoid the unsatisfactory mumbo-jumbo that try to 'explain' the ups and downs of the markets on any particular day that one sees on TV or in the newspapers, trying to stick to the higher purposes of this blog, etc.). I believe that I have done a pretty good job of trying to be current but not too current with the Econophysics Blog.

However, I felt I needed to make an exception in this case. Recently, there have been some down movements in world equity markets. By now, this downturn has even spread to the commodity markets (something that goes against most people's intuitions about correlations between the different markets). There is a general unease in the air.

This reminded me about what I had been reading and seeing about a month or so ago. Back in those 'good old days' (which really wasn't so long ago if you think about it), there was a lot of talk about how low the VIX was (around 11 or so ... it abruptly jumped higher since then). VIX is the acronym for the Chicago Board Options Exchange's Volatility Index. The VIX is essentially the measure of the 'implied volatility' (as define by the Black-Scholes options pricing formula) of the options on the S&P 500 index. The VIX is widely considered to be (for very valid reasons) the best gauge of the market's consensus guess on the future direction of volatility (hence 'risk'); based on rational expectations reasoning, this would make VIX the best measure of future volatility (at least the best measure that is widely accepted and available).

It should be obvious by now that the VIX is a flawed measure of future risk since the VIX has failed to anticipate the current wide-scale downturn in the financial markets (across geographic and asset-class boundaries). Only a few short weeks ago, the VIX was relatively low and was 'predicting' tranquil markets. Now serious people are beginning to think we might be in crises mode (although I'm not sure if I'd go that far at this point). Of course, the VIX has abruptly jumped to higher levels since then, but this hardly justifies putting much faith in it as an accurate predictor of future risk ... it's like closing the barn doors after the horses have ran away.

What's been happening lately should be considered as more evidence of the wild and jumpy nature of financial risk.

-- Addendum --

Since writing the above posting, I found one of the articles I had read talking about the recently low levels of the VIX (from the May 11, 2006 -- almost exactly a month ago -- issue of The Economist): The fear gauge (this article actually did an excellent job of predicting what has transpired over the last month or so). According to that article:

For instance, on only eight days this year has the S&P 500 index moved by more than 1%, compared with 12 times a month in the wake of the dotcom bust, and 11 times a month during the great sell-off in the 1970s ... Meanwhile, the Chicago Board Options Exchange's Volatility Index (VIX), which measures the share movements implied in stock index options, is at record lows. It predicts that the S&P 500 will move by less than 1%, up or down, over the next month.

To put it mildly, over the last month, the markets have moved down by more than 1% since May 11th of this year!

The article goes onto deliver what has turned out to be some perceptive Jeremiads:

To stockmarket bears, however, low volatility is a warning sign: too much stability may, paradoxically, be destabilising. Ed Easterling of Crestmont Holdings, a Dallas investment firm, calls it “the calm before the storm”. He worries that speculators may have become overly complacent. “The current state of volatility is an indicator of potentially sharp stockmarket decline,” he says.

Episodes of extremely low volatility rarely last long, says Mr Easterling, and are usually followed by periods of exceptionally jumpy prices. There is, indeed, evidence that an increase in volatility often means a sell-off in markets.

As it turns out, the contrarians -- rather than VIX -- turned out to be right.

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