by Rohini Grover and Ajay Shah
A remarkable feature of options trading is that it reveals a forward-looking measure of the market's view of future volatility. This was first done by CBOE in 1993 with the S&P 500 index options, with an information product named `VIX' which reveals the market's view of future volatility of the US stock market index.
CBOE computes and disseminates VIX every 15 seconds. VIX is often termed a `fear index' as it conveys the fears of the market. It has found numerous applications:
Time-series econometrics processes historical data to help us make statements about the future. VIX brings a unique forward-looking perspective into time-series analysis.
VIX measures uncertainty in the economy e.g. when examining the effect of macroeconomic shocks (Bloom, 2009).
The international finance literature has emphasised the role of VIX in shaping capital flows to emerging markets [example]. E.g. it is interesting to look at what happened in India on the days in which a very large rise or fall of the VIX took place.
Trading strategies can be constructed which employ VIX as a tool for making decisions for switching between positions.
VIX based derivatives offer methods to directly trade on VIX. In the US, CBOE introduced VIX futures and options on March 26, 2004 and February 24, 2006 respectively. In 2012, the open interest for these contracts was at 326,066 contracts and 6.3 million respectively. In India, futures on VIX have been launched at NSE, but the contract has not taken off.
All of us treat VIX as a hard number — we talk about a value of VIX such as 24.53 as if it is known precisely. But VIX is computed from a set of option prices. These option prices suffer from microstructure noise and from the limits of arbitrage. Each option price is only an imprecise reflection of the thinking of the market. This raises concerns about the extent to which imprecision in option prices spills over into imprecision of VIX.
