Wednesday, January 6, 2010

A critique of Credit Suisse Fear Barometer (CSFB) index (uptd)

Credit Suisse recently launched a fear index, Credit Suisse Fear Barometer (CSFB Index) which the firm expects to replace the most prominent ‘fear’ index, VIX. The idea behind the CSFB Index is to quantify fear by putting a zero premium collar on the underlying asset. This combination trade consists of selling a call option of strike 10% above the spot by receiving Rs. X as premium and buying a put of strike Y% lower than the spot by paying a premium of Rs. X, thereby the initial net outlay is zero. The owner of the combo trade is ready to sacrifice gain exceeding 10% in return cuts the loss to the maximum of Y%. The CSFB Index is nothing but this ‘Y’. The report’s contention is that more the Y% lesser is the protection one is getting hence this is an indicator of fear. Following are counter points that argue against the claim that CSFB Index is better than VIX.

  • For the above italicized assumption the counter could be that when Y% > 10% the trader won’t put in a collar trade unless he is bullish since he would be betting 10% upside against Y% downside. We see that the CSFB index peaked before the crisis as the traders were over confident or irrationally exuberant. Hence prima facie the index is not reflective of fear among investors

  • The price of an option is a function of five factors as per Black Scholes and measuring fear just by price is flawed. The interest rate, an often ignored factor, justifiably over short period can’t be ignored when developing an index as the prices are impacted by the prevailing interest rate regime. When interest rate rises and other factors maintain status quo put price declines while call rises. We know that Call = S * N(d1) – PV (Strike) * N(d2) and Put = PV(Strike) * N(-d2) – S * N(-d1) and as interest rate rises PV(Strike) declines hence price of put decreases and that of call increases. And hence for the collar trade the trader might have to go deep Out of The Money (OTM) which increases Y% which in turn leads to rise in the index. We see that though the index is choppy both the index and 3 month government yield trend together. The argument is that though interest rate is comparatively minor factor during high interest rate regime it certainly matters in pricing options
Since the index lacks fundamental backing it pales as a measure of fear against VIX. On the contrary the index can be used assess the level of irrational exuberance among investors.