VIX, SKEW and CSFB – are you afraid yet?

First of all, this post is simply another (simplified, I hope) version of http://www.zerohedge.com/article/forget-vix-skew-tells-true-story-about-market-risk. I claim no credit for any original thought in this post.  One thing to keep in mind when looking at volatility (low volatility, in particular) is what Nicholas Colas of ConvergEx said in 2014 – “Complacency isn’t an overnight guest. It moves in and stays longer than you ever thought possible.”.

Okay, now to the meat of the post –

We all often discuss VIX as the fear barometer since it measures the “volatility in the market”. Let us qualify this statement a little. VIX measures near-term (30-day) volatility of the S&P 500 index option prices. It used to use only the at-the-money series, but now includes options with wider strike prices. How does this work? From the horse’s mouth itself – “VIX is based on real-time option prices, which reflect investors’ consensus view of future expected stock market volatility. During periods of financial stress, which are often accompanied by steep market declines, option prices – and VIX – tend to rise. The greater the fear, the higher the VIX level. As investor fear subsides, option prices tend to decline, which in turn causes VIX to decline. It is important to note, however, that past performance does not necessarily indicate future results” (see http://www.cboe.com/micro/vix/faq.aspx)

So, now we can see two problems with VIX as a complete fear gauge. First, it measures 30-day volatility, and hence doesn’t capture what options market may be pricing farther from one month (obvious assumption is that equity market is not pricing uncertainty of that event fully yet, else that vol will show up in the 30-day vol). For example, market may be awaiting a critical event that is more than a month away, and there may be significant uncertainty around that, and will impact several asset classes, but VIX will not capture it. Second, VIX measures primarily at-the-money options and options are strike prices that are presumably closer to the at-the-money strike price–this means that VIX discounts tail risk. For example, if SPX is priced at 130, and the market believes that it will drop sharply, it will buy out-of-money puts to hedge against that risk–this view is unlikely to show up in a discernible form in VIX. How do we address this? We can look at two additional parameters.

#1 – CSFB  : CSFB tries to address the first problem that we outlined above by looking at a 3-month horizon. It prices a zero-cost collar by selling a 10% out-of-money call and using the proceed to buy an out-of-money put; the index represents how out of money that 3-month SPX put is–more out-of-money put implies more fear about import of events 3 months out.

#2 – SKEW : SKEW demonstrates the difference between a weighted strips of out-of-money options and at-the-money options for a 1-month duration. Greater the spread, more the near-term fear of a significant move. See more details at http://www.cboe.com/micro/skew/documents/SKEWFAQ.pdf

As is obvious, we can’t use SKEW or CSFB to replace VIX; they simply add more color to the picture.

Vol for currency and oil: For currencies, you can use CVIX, and for oil OVX.

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