The concept of a Volatility Index was first developed by the CBOE (Chicago Board Options Exchange) in the early 1990s, although the mathematics behind it goes back to the 1970s. Also called VIX, it is a tool that investors in the stock markets use before buying or selling stocks. In simple terms, VIX refers to a market’s expectations of price ‘volatility’ or fluctuations in the next 30 days.
In India, market volatility is determined using the NIFTY 50 index. The results are known as India VIX. India has 2 major market indices which are carefully followed both by listed companies and investors. One is the Bombay Stock Exchange’s SENSEX or simply BSE SENSEX. The second is the National Stock Exchange’s NIFTY. The NSE’s NIFTY 50 is based on the weighted average of the 50 largest companies in terms of market capitalisation, which are listed on the NSE.
Using the India VIX, economists and market watchers can determine the extent of confidence or fear among traders. Hence, VIX is also called a ‘fear index’ on occasions.
What is the Volatility Index?
To understand a Volatility Index, one needs to go back to the 1970s when there was no significant method of determining investor confidence. The markets often ran on speculation. It made determining a stock’s ‘fair price’ extraordinarily difficult.
In 1973, three economists- Fischer Black, Robert Merton and Myron Scholes devised a model that changed the process of option pricing. The ‘Black Scholes Model’ is currently used globally to measure market volatility.
For their pathbreaking work, the trio won Nobel Prize for Economics in 1997. However, Merton had passed on before that year, and the model is named after the remaining survivors.
The model is represented as follows –
When: d1=σs tlnKSt+(r+2σv2) t
plus: d2=d1−σs t
In this model, the legends mean the following –
C= Call option price
S= Current stock price; another underlying price (s) may be considered
r= Interest rate (risk-free)
K= Strike price
N= an ordinary/normal distribution
t= time to maturity
In India’s stock markets, VIX serves several purposes. Some of the critical ones are as follows –
- Market volatility and India VIX have parallel trajectories – Thus, if there is a significantly high VIX, investors can reasonably assume that there will be some noteworthy announcements or developments in the NIFTY. In other words, a higher VIX indicates high market volatility. Since the NIFTY 50 is a benchmark index, any change may have a profound impact on the entire economy.
To sum up, investors must keep a watch on recent trends in the VIX as it can project future developments. If the index is low, no major development is expected.
- There is a negative correlation between India VIX and NIFTY – For example, if India’s Volatility Index is on the higher end, NIFTY’s benchmark index will drop. If VIX is low, this benchmark will be significantly higher. If one looks back at the Subprime loan crisis in 2008-’09 alongside Lehman Brothers’ (an investment and financial services giant founded in 1847) subsequent bankruptcy, it will be obvious that the NIFTY index was in doldrums.
Around the world, whenever there has been a colossal impact on the global economy due to extraneous events, the Volatility Index meaning has undergone a change. The formula to calculate this index, given below, has undergone slight tweaks after each such incident.
In 2001, just after the September 11th hijackings and attacks on the Twin World Trade Centre Towers and the Pentagon, VIX worldwide climbed to all-time highs.
- Helps investors determine market sentiments – One of the most important purposes that a Volatility Index serves is aiding any investor, retail or institutional, gauge the mood of a market. A close watch of the VIX gives an idea of whether one should buy certain stocks or sell them at current prices.
The pandemic in 2020 is a case in point. Once the nationwide lockdown was announced in March, markets slumped. Indian equity lost almost 40% of its net value, a major economic shock which will take several years to recover from. It was a sign to most indicators that they should ‘dump’ their stocks at whatever price brackets they were receiving; there was fear that most stocks would lose all value after a few months.
At one point, all trading was put on hold since companies saw their market capitalisation erode rapidly.
Around November, the stock markets are flying high once again, which means that the Volatility Index has gone down. It also indicates that investors have confidence that India’s economy has enough resilience and strength to ward off the blues and will resurge in the near future.
Low India VIX levels in November also highlights that there is very little chance that India’s economy will slip into recession, which is technically defined as a contraction in 3 consecutive months. Already, the United States’ economy has entered a recession, sparking fears that its ripple effects will mute all positive market sentiments of other major global economies.
New or inexperienced investors must be careful before they put in large amounts of money in the market. It is advisable to analyse a market’s Volatility Index over the previous 2-3 months at least and then take decisive steps.
India VIX assumes even greater significance as its Central Government steps in to stimulate faltering sectors of the economy.