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VIX Needs A Fix

The Volatility Index would prove to be a good tool is it is reviewed to fit the Indian liquidity constraints

All Indian stock-derivatives are cash-settled and this has contributed to the rapid growth of the F&O market. In fact, in the absence of an official stock-lending mechanism, derivatives were the only instruments available to exploit price downtrends.

A new stock-lending mechanism, the SLBS was announced recently but it has not taken off. Volumes have been low and institutions have been unenthusiastic. Bears obviously find short stock futures and Nifty puts more convenient for their operations, while FIs are reluctant to actually lend stock. Another recent launch, the volatility index (VIX). In any case, there are no trades available on the new VIX, yet. VIX is sophisticated - it is a derivative of derivatives. It's supposed to be a measure of "fear" in the market.

The Indian avatar of the VIX exactly copies the methodology of the CBOE (Chicago Board of Options Exchange), which devised the original VIX. The VIX is based on the concept of implied volatility and it derives a weighted average measure of implied volatility through the reverse solution of index option premiums.

The idea is, since we know the price of the underlying, the expiry period, the intrinsic value etc, we can derive a "Fair value" premium for a given option at a given strike price. The difference between fair value and the real premium must be due to volatility expectations or implied volatility (IV).

The VIX takes the IV of a whole range of options, both in-the-money and out-of-the-money, and weights them according to liquidity and then averages to derive a volatility estimate. In mathematical terms, volatility covers both up and down moves and so in theory, a high VIX need not have directional implications.

But in practice, it has been noted on the CBOE, that volatility rises very noticeably in a bear market. Over many years, US VIX-watchers have deduced that there is an inverse correlation between price-trend and implied volatility. When prices are rising, IV is low and when prices are falling, IV is high. This correlation is so strong that it ranges above - 0.8. Some analysts have isolated VIX maxima-minima levels where the market is markedly oversold/ overbought respectively.

Once that inverse relationship was decoded, the US VIX (and other instruments modelled up it) became very closely watched instruments. You can use the VIX as the underlying in a futures or options instruments and one leg of exotic derivatives is often the VIX. The Indian VIX has only been in operation for a couple of months and the NSE has released back-calculated data on the VIX only till November 1, 2007. That is not nearly long enough to derive maxima/ minima values for oversold and overbought levels. While there is clear inverse correlation noted in the desi VIX, it is not nearly as strong as that seen in the US.

It's true that the market has seen historic peaks in 2008 and it has also seen a 35% fall from the top. It's true that the VIX has generally been low when the Nifty was trading high and vice-versa. A few traders have tried developing convergence-divergence trading models. But it's not a strong enough or well-defined relationship to trade on very reliably yet.

The CBOE uses IV of S&P 500 options to construct its VIX. Close to the monthly settlement, about 8 sessions in advance, the US VIX starts considering mid+far month options instead of near+mid month options.

Since the Indian market doesn't offer an option on the S&P 500, it uses the Nifty options to calculate IV. Also Indian markets lack liquidity in far month contracts. Even right after settlement, the open interest in mid+far Nifty options is generally very low, often less than 10% of outstanding OI. You also don't have liquidity in the Nifty option chain at strikes over 12% out from the money so the premium pricing is suspect.

As a result, the VIX methodology probably introduces some distortions to India since it over-weights illiquid, low-volume options. The fact that the Nifty is a narrow large-cap index would also reduce the effectiveness a little.

Nevertheless the market is tracking the VIX already. If the methods are reviewed to fit to Indian liquidity constraints, it should prove to be a good tool. If there are instruments based on it, they will generate trading volumes. The SLBS will need a more major overhaul to catch on.