The Fear Factor: Volatility Index in the Spotlight

VIX creator sets the record straight on key gauge of investor anxiety

As the world financial panic set in motion by the subprime mortgage crisis reached full steam in late September, Bob Whaley's phone began ringing. Interest in what financial writers call the Fear Index was spiking as stock prices plummeted and major Wall Street firms collapsed, and much of it was directed his way. The Fear Index, which is more properly known as the Chicago Board Options Exchange Market Volatility Index (VIX) and which has offered a real-time gauge of market jitters since 1993, was, after all, Whaley's brainchild.

Whaley, Valere Blair Potter Professor of Management and an expert in derivative securities, did some interviews, but became increasingly annoyed by the articles and commentaries he saw. One after the other contained assertions he saw as "utter nonsense"—that the VIX was a self-fulfilling prophecy, that it was at unprecedentedly high levels, that it was a "contrarian" indicator.

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"People were saying all sorts of unsupportable things," he says, "so I decided to write a short piece that puts everything in proper perspective and corrects misconceptions people have because they haven't dug deeply enough."

For most people, the VIX, like the wider world of derivatives it reflects, skulks in a back alley of the financial world until there is a crisis, when it is hauled in for questioning that amounts to hysterical accusation rather than rational information gathering. What's more, the recent fates of even the biggest, most savvy firms make clear there was more than enough ignorance—coupled with greed—to go around. If ever a subject called for light rather than heat, it is this one.

"It is not new," Whaley says of the index. "It is not at unprecedented levels. And it does not cause volatility."

It is, he contends, simply "a measure of expected stock market risk" set by the actions of investors as they work to protect their assets. More fully, the VIX is a weighted blend of prices for options on the Standard & Poor's 500 Index (prior to September 22, 2003, it was the S&P 100). Those options are in essence insurance policies protecting investors against broad-based market swings. The premiums they are willing to pay indicate their level of apprehension—hence the term Fear Index—about the market volatility they anticipate in the short term.

Whaley is amused by claims that the VIX is a "contrarian" indicator.

"One commentator said in September that since the VIX was above 35 it was time to buy stocks," he says. "The only time a contrarian indicator makes sense is after the fact. While 35 might have been high relative to its recent history, it increased steadily to a level of over 80 in the days afterward. If you'd taken his advice you'd have lost your shirt. The stock market fell by nearly 30 percent."

He is similarly dismissive of its power as a self-fulfilling prophecy that adds to market anxiety.

“This type of thinking is exactly backward. The degree of market anxiety is reflected in investor demand for portfolio insurance, which sets the level of VIX. Saying that the market is better off without the VIX is akin to an ostrich hiding its head in the sand.”

As for historic highs, the VIX is in one sense nowhere near them—projected backward, it reached its peak during the October 1987 market crash, spiking to levels well above 150. Since September 2008—the month that marked the beginning of the stock market’s deep dive—the VIX has not exceeded 90. On the other hand, its recent sustained level of more than 35 marked only the fourth time the index had spent more than 20 days in that range.

"So, yes," says Whaley, "we are experiencing abnormal behavior, but, no, it's not unprecedented. We just tend to forget."

During 2002, the typical closing level of VIX was nearly 30, well above 2007’s level of 16.33. Still, Whaley wants to make it clear that it is a reflection of nervousness rather than a cause.

"The levels of index option prices," he says, "are merely translated into a number that has the interpretation of being the level of expected stock market volatility over the next 30 days."

CBOE approached Whaley, then a professor at Duke, about creating the index in 1993, telling him it wanted both a consistent measure of market volatility and "an index upon which futures and options contracts could be written." Whaley weighed formulas while on sabbatical in France and returned with the VIX. As a measure of volatility, it has proven to be a useful analytic tool, although it remains a largely obscure calculation until times of great turmoil, when it becomes a loudly quoted favorite of cable news and financial commentators. It took more than a decade for its second purpose to be fulfilled, though—it was 2004 before investors could buy and sell futures contracts on the VIX and 2006 before options were available. And while both are, in a very real sense, derivatives on a derivative in a world skeptical of such things, Whaley is quick to defend that use of the VIX.

"The market wanted a cost-effective mechanism for buying and selling volatility," he says, "and that's a good thing. During periods of increasing market anxiety, people bid up the prices of index options and drive up the level of VIX. There has to be a means of bringing in people interested in selling volatility when the price of insurance is too high. It's no different than what happened when oil spiked to levels above $150 a barrel. Eventually someone said, ‘I'll sell at that price.' Others joined in and the price fell. If people are barred from selling, as most people are without a futures or option market, the market for oil or volatility, as the case may be, is slower to adjust to new information and is, therefore, less efficient."

But while derivatives contracts on VIX are far from mainstream, Whaley hopes a clear understanding of them—they measure the fear of swings in the stock market—will make them seem less so.

"People have their money on the line in setting the VIX number," he says. Oftentimes VIX rises when the stock market falls. Yet he points to other times, as in the dot-com run-up of the late ’90s, in which the VIX was going up even as the NASDAQ was rising dramatically. "Amazingly, people out there were protecting themselves against a stock market drop even though the market was going up," he says. “How right they were in doing so!”

Like those of other market indexes, the level of VIX is based on market prices. Where the S&P 500 index reflects the collective wisdom of investors on the fair values of the underlying stocks, the VIX reflects the collective wisdom of investors (albeit a narrower group) on the fair value of insurance—S&P 500 index option prices.

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