Monday, October 20, 2008

The tale of two VIXes
VIX is an index of implied volatility on S&P 500 which was launched almost three decades ago. VIX is supposed to be a measure of investors’ sentiment and it is similar to Credit Default Spread (CDS) indices. Both, VIX and CDS, are proxies for risk premium.
VIX has been making history recently and on Friday (17th Oct 2008) it closed at 70.3 volatility points which is about 25 vol points above the peak registered during the dot com crash. This means that the current crisis would be worse than the dot com burst, just short of depression as many economists from academia predict. Economists from Investment Banks are a corrupted lot; you can trust them at your own peril.


Who caused this crisis?

Some point finger at Greenspan. It seems to be the case, though the economy sputtered even before the dot com burst the contraction of the economy was just normal course correction. And bubble was more to do with tech sector and not the entire economy. As the following chart shows, the system had ample liquidity as indicated by low TED spread. So the case for rate cut by the Fed and maintain it at paltry 1% for many months is weak. Unwarranted money printing by Fed led to excess liquidity which led to steep fall in risk aversion. I remember a strategist from a British bank saying in Jan 2007 that he expects the spreads of BBB rated corporate to compress by 15-20 bps when the spreads were trading at atrociously low levels of 50-60 bps. Let us just hope that recent liquidity injection doesn’t create another bubble.





NSE VIX
NSE launched Indian VIX in November 2007 and this measure has been averaging around 34.5 vol points and was trading above the American VIX, which is in line with fundamental reasoning that despite many growth stories spun around India, US is still a economic power house (it might be dying) and India has miles to go. But since September, US VIX is trading at a premium as against Indian VIX which shows that the investors are asking for lesser risk premium for Indian assets. This seems to be an aberration at least in short term.



Another point to be noted is that the NSE implied normally trade at discount of around half vol points on average to realized volatility. Implied volatility being about future should have premium over the realized volatility.

Indian VIX seems to under pricing the risk in the market both from relative basis and historical basis.