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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Comments (6)

1. Posted by Bill Sjostrom on October 21, 2008 @ 15:36 | Permalink

One way to look at the VIX is reflective of the demand for put options. As portfolio managers become more fearful of future market declines, they reduce their market exposure by buying S&P 500 put options. This increases the demand for these options which increases their prices. Since all the inputs into the option pricing model other than volatility are relatively fixed and known, the increased prices translate into increases in implied volatility of these options and therefore a jump in the VIX (the VIX is based on the prices of a basket of S&P 500 options). Hence, an increase in the VIX may reflect an increase in put demand which reflects an increase in fear about market declines. Thus, I don’t think it is as misleading as you suggest to call the VIX the Fear Index.

2. Posted by Errol on October 21, 2008 @ 18:10 | Permalink

Nice post Bill. I think your comments are far more accurate than those of this article. Traders use SP500 puts as protection, when the vix increases, its because traders are either taking more insurance or believe the market is heading down.

3. Posted by fedgovernor on October 22, 2008 @ 3:26 | Permalink

If I believe the market is heading down, and I buy SP500 puts ... is that fear?

Or is it merely prudence?

One less inclined to sell newspapers might call the VIX the "Prudence Index."

I buy homeowners insurance not because I fear my house will burn down, but rather because it is prudent to buy insurance. If I really feared my house would burn down, I wouldn't live in it.

4. Posted by Taxrascal on October 23, 2008 @ 13:31 | Permalink

The VIX might be an index of their fundamental fear, versus their fear about their own portfolios. So a high VIX doesn't mean that the average investor expects to lose 20%, but that the average investor has hedged so that a 20% loss in underlying value wouldn't hurt the portfolio so much.

And fedgovernor: it's not a prudence index unless you assume that stocks are overpriced and bound to fall further. If you think that the market is fairly priced, or undervalued, it is extremely imprudent to buy puts right now.

5. Posted by market data excel on March 7, 2011 @ 4:03 | Permalink

Recession is a part of market it can be illuded but can't be avoided. Market is really unsure but It is necessary to keep up with it.

6. Posted by implied volatility on March 7, 2011 @ 4:06 | Permalink

The prediction has come true, but the market is still in dubious situation.

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