October 21, 2008
The VIX is not a Fear Index
Posted by Mike Guttentag

The lead article in the business section of yesterday’s New York Times describes the VIX index (the Chicago Board Options Exchange Volatility Index) as “the Fear Index.”    The NYT’s article explains that a “rising VIX is usually regarded as a sign that fear, rather than greed, is ruling the market.”  Although this may be the generally accepted nomenclature, it is misleading to describe what the VIX measures as indicative of the level of “fear” in the market.

The best way to understand the difference between what the VIX measures and our common sense notion of fear is through the use of an analogy.  Think of the equity markets as a person driving along a curvy road.  Suppose we ask that person: how curvy is the road up ahead?  The driver answers: “the road gets much curvier up ahead.”  Now suppose that same person is driving along that same curvy road, and suddenly slows down.  We ask the driver what happened, and he says: “all of a sudden I am not very comfortable driving around those curves at such a fast speed.”  Clearly the second scenario is much closer to our notion of an increase in fear than the first.  Would it even be logical to conclude based on the first scenario that the driver had become more fearful?  Perhaps the driver in the first scenario is simply acknowledging that the terrain is more challenging ahead.

Let me now translate this analogy into finance terms.  The VIX measures how curvy people expect the road ahead will be, not how fast people are willing to drive.  But it is the willingness to drive quickly on a curvy road which comports with our sense of what it means to be more or less fearful.  The metric that tracts the willingness to drive quickly is the return that the marginal investor demands in exchange for holding a risky asset, which is the equity risk premium.  In an earlier post on this blog I discussed how a stock market crash can be explained in terms of a sudden increase in the equity risk premium demanded by the marginal investor.  This would be analogous to the average driver suddenly choosing to drive much slower, a choice made because of an increase in fear.  Such a change, which would be matched by a dramatic drop in the value of equities, provides a better measure of an increased level of “fear” in the market than the VIX index.

Though the more accurate metric, there are certain limitations in using the marginal investor’s equity risk premium as an indicator of the level of “fear” in the market.  First, no index exists to measure the marginal investor’s willingness to hold risky assets at a given time.  Thus, this metric proves useless in generating a number that can be tracked by CNBC.  Second, in early finance work the equity risk premium was assumed to be fixed over time, suggesting that the level of fear in the market was essentially static.  However, the assumption of a fixed equity risk premium was largely used for simplification, and financial economists now reject the assumption that the equity premium does not change. We should not use the VIX as a measure the level of “fear” in the market, as it only leads to a misinterpretation of attitudes toward risk in the market.

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