with aggregate profits negative, the equity market as a whole was trad-
ing like an out-of-money option.THE VOLATILITY INDEX (VIX)
Measuringhistoricalvolatility is a simple matter, but it is far more im-
portant to measure the volatility that investors expectin the market. This
is because expected volatility is a signal of the level of anxiety in the mar-
ket, and periods of high anxiety have often marked turning points for
stocks.
By examining the prices of put and call options on the major stock
market indexes, one can determine the volatility that is built into the mar-
ket, which is called the implied volatility.^11 In 1993, the Chicago Board Op-
tions Exchange (CBOE) introduced the CBOE Volatility Index, also called
theVIX Indexor the VIX, based on actual index options prices on the S&P
500 Index, and it calculated this index back to the mid-1980s.^12 A weekly
plot of the VIX Index from 1986 appears in Figure 16-4.
In the short run, there is a strong negative correlation between the
VIX and the levelof the market. When the market is falling, investors are
willing to pay more for downside protection and they purchase puts,
causing the VIX to rise. When the market is rising, the VIX typically goes
down as investors gain confidence and are less anxious to insure their
portfolio against a loss.
This correlation may seem puzzling since one might expect in-
vestors to seek more protection when the market is high rather than low.
One explanation of the behavior of the VIX Index is that historical
volatility is higher in bear markets than bull markets, so falling markets
should cause the VIX to rise. But a more persuasive argument is that
changes in investor confidence change investors’ willingness to hedge
by buying puts. As put prices are driven up, arbitrageurs who sell puts
sell stocks to hedge their position, thus sending stock prices down. The
reverse occurs when investors feel more confident of stock returns.
It is easy to see in Figure 16-4 that the peaks in the VIX corre-
sponded to periods of extreme uncertainty and sharply lower stock
prices. The Volatility Index peaked at 172 on the Tuesday following the
October 19, 1987, stock market crash, far eclipsing any other high.CHAPTER 16 Market Volatility 281
(^11) This is done by solving for the volatility using the Black-Scholes options pricing formula. See
Chapter 15.
(^12) Until 2003, the VIX Index was based on the S&P 100 (the largest 100 stocks in the S&P 500 Index).
See the CBOE Web site (www.cboe.com) for more details on its calculation.