How Well Does the Market Predict Volatility?

The CBOE Volatility Index (VIX) got here on the scene within the Nineteen Nineties as a approach for traders to trace anticipated threat out there going ahead. The Chicago Board Choices Trade’s VIX does one thing distinctive in that it makes use of 30-day choices on the S&P 500 Index to gage merchants’ expectations for volatility. In essence, it offers us a ahead estimate of what the market thinks volatility in equities goes to be.

However how correct is that this measure on a realized foundation and when does it diverge from the market? We tackled this query by evaluating the total spectrum of VIX information going again to 1990 to realized volatility of the S&P 500 Index. We discovered that, on common, the market overestimated volatility by about 4 proportion factors. However there have been distinctive instances when there have been important misestimations by the market. We inform this story in a collection of reveals.

Exhibit 1 is a picture of the total time collection of knowledge. It exhibits that, on common, the VIX overshot realized volatility constantly over time. And the unfold was constant as properly, aside from throughout spike intervals (instances when markets go haywire).

Exhibit 1.

In Exhibit 2, we summarize the info. The typical S&P 500 Index realized volatility on a 30-day ahead foundation was 15.50% over the 35-year interval. The typical VIX (30-day ahead estimate) was 19.59% over the identical interval. There’s a 4.09% unfold between the 2 measures. This suggests that there’s an insurance coverage premium of 4.09 proportion factors on anticipated volatility to be insulated from it, on common.

Exhibit 2.

Subsequent, we flip towards a time when no main disaster occurred: from 1990 to 1996. Exhibit 3 highlights how markets labored throughout these regular instances. The VIX constantly overshot realized volatility by roughly 5 to seven proportion factors.

Exhibit 3.

Exhibit 4 depicts a really completely different interval: the 2008 world monetary disaster (GFC), and we will see a really completely different story. In July 2008, realized volatility on a 30-day, forward-looking foundation started to spike over the VIX. This continued till November 2008 when the VIX lastly caught up and matched realized volatility. However then realized volatility fell again down and the VIX continued to climb, overshooting realized volatility in early 2009.

Exhibit 4.

This seems to be a normal sample in panics. VIX is sluggish to react to the oncoming volatility after which overreacts as soon as it realizes the volatility that’s coming. This additionally says one thing about our markets: The Federal Reserve and different entities step in to quell the VIX as soon as issues look too dangerous going ahead, thereby lowering realized volatility. In Exhibit 5, we noticed this dynamic once more in the course of the COVID interval.

Exhibit 5.

The Reveals yield two attention-grabbing takeaways. One, traders, on common, are paying a 4% premium to be protected against volatility (i.e. the distinction between the VIX and realized volatility). Two, the market is constant on this premium; is sluggish to initially react to massive, sudden occasions just like the GFC and COVID; after which overreacts.

For these which can be utilizing VIX futures or different derivatives to guard in opposition to catastrophic occasions, these outcomes spotlight how a lot of a premium you’ll be able to anticipate to pay for tail threat insurance coverage in addition to the danger you absorb overpaying throughout instances of market panic.

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All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the writer’s employer.

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