The VIX, Volatility and Market Risk

Posted by Erika Alter, Global Head of Commercial Strategy, BISAM on Nov 30, 2016 10:32:33 AM
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Just before the Thanksgiving holiday in the U.S., the Financial TimesTM published a piece by Miles Johnson, Tail Risks Wagging the Dog with Wall Street Fear Gauge. In his piece, Mr. Johnson notes, “the risk for any human or computer using the VIX as a gauge of how risky or safe the market may be is that there are reasons to believe it has become an increasingly scrambled signal over the past five years.” He continues on to suggest that, “Stock market investors who have been finding solace in apparently subdued volatility may one day be in for a violent awakening.”

Putting aside Mr. Johnson’s question re: whether or not the VIX is being influenced by the huge volumes being traded in short-dated VIX futures, we at BISAM think the more important point is the noted cause for concern for “anyone currently using the VIX index as an independent variable to inform their decisions.”

The VIX, popularly known as the “Fear Index,” is the market’s primary measure of expected future volatility, and has been closely watched since the 2008 financial crisis as a “forward-looking measure for market stress and riskiness.” While the FT piece and many others in the industry have questioned if the VIX is the right measure of future volatility, perhaps the real question is whether volatility is the right investment decision-making measure for market risk?

Those of you who follow our risk research know that the BISAM Cognity fat-tail methodology redefines risk. It does not assume risk equals volatility, but rather measures the following:

1. Volatility of volatility (turbulence) - we measure market turbulence (“vol of vol”) as an additional risk indicator, based on the idea that “turbulence is the new normal” and volatile markets follow turbulent markets, in the sense that the "vol of vol" can be high when the volatility is still low at absolute levels. 

2. Deviation from normality - to analyze the current market environment, we typically look at different markets and factors comparing the current Fat-tailed versus Normal VaR spread for each one of the segments to the average values observed during various important historical periods. See our Daily Risk Statistics as an example of this:

3. “Tail-fatness.”  - in normal markets, tail risk dissipates rapidly, but in turbulent markets we see tails decrease slowly. In other words, the probability of extreme events decreases more slowly in turbulent markets than normal markets.

Thanks to the economist Harry Markowitz, the industry has typically defined risk as “volatility.” These days, however, most practitioners know that volatility alone is not a good measure of risk, as it is strictly a measure of dispersion, not tails or asymmetry as mentioned above.

So, while the industry understands that volatility is not the best measure of risk, why are so many firms still decomposing risk based on volatility rather than turbulence and other factors? Is it a lack of innovation within some organizations? A hindrance caused by technology? Tell us what you think via the comments below.

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Topics: Risk Management

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