An Introduction to VIX

Volatility has emerged as an important asset class in its own right over the past decade. Book-ended by two equity bear markets, the past decade (2000 – 2010) saw heightened financial stresses and large losses in investment portfolios. The investment community’s need for tools and instruments to protect downside risks had never been more acutely felt. As the saying goes, necessity is the mother of invention, and this sentiment holds true in the realm of financial engineering.

Since its introduction in 1993, the VIX, the Chicago Board of Options Exchange’s (CBOE’s) volatility index, has become widely considered the “fear gauge” of the market. The VIX measures the implied volatility of S&P 500 index options, representing the market expectation of stock market volatility for the next 30 days. Market participants quickly discovered the value of the VIX index in hedging portfolio risks, since the VIX was found to be negatively correlated with the returns of the equity market, as measured by the S&P 500. Furthermore, the level of correlation increases as the equity market sells off. Due to this asymmetry in correlation, the VIX is an ideal hedge for a long-only equity portfolio.

Recognizing the importance of the VIX index, a host of new products based on the VIX were introduced in the past decade. In 2004, the CBOE Futures Exchange (CFE) introduced futures trading on the VIX, and the CBOE listed an options contract on the VIX in 2006. In 2009, S&P Indices introduced the S&P 500 VIX Futures Index Series, which is now the basis for a growing list of more than two dozen ETNs and ETFs, linked to more than US$ 2 billion in assets (Liu and Dash, 2011). These instruments have driven the VIX’s evolution from a market indicator to a hedging vehicle.

The posts on this blog are opinions, not advice.
Please read our disclaimer for Indices.

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