The Volatility Index measures the market's anticipation of volatility in the near term. During moments of market volatility, the market typically moves sharply up or down, and the VIX tends to climb.
VIX falls as volatility falls. It is not the same as a price index like the NIFTY. The price index is calculated by taking the price movement of the underlying equities into account. The Volatility Index is calculated as an annualized percentage using the order book of the underlying index options.
The India VIX is a volatility index calculated by the NSE from the order book of NIFTY options. The best bid-ask quotes of near and next-month NIFTY options contracts traded on the NSE's F&O segment are used for this.
India VIX reflects investors' perceptions of market volatility in the near term, i.e. it portrays market volatility over the next 30 calendar days. The higher the India VIX number, the greater the predicted volatility, and vice versa.
India VIX employs the CBOE's computing technique, with appropriate modifications to adapt to the NIFTY options order book, such as cubic splines, etc.
The following elements are taken into account in the calculation of the India VIX-
To achieve the degree of precision anticipated by experienced traders, the time to expiry is calculated in minutes rather than days.
The relevant tenure rate, which is for 30 to 90 days, is considered the risk-free interest rate for the respective expiry months of the NIFTY option contracts.
India VIX is computed using the out-of-the-money option contracts. It is identified using the forward index level.
The forward index level helps to determine the at-the-money strike which in turn helps in selecting the options contract which shall be used for computing. The forward index level is taken as the most recent available price of the NIFTY future contract for the respective expiry.
The ATM strike is the strike price of a NIFTY option contract available slightly below the forward index level.
Option NIFTY option and call contracts with strike prices higher than the ATM strike Out-of-the-money options are put contracts with a strike price less than the ATM strike, and the best bid and ask prices for such option contracts are used to calculate the India VIX.
In the case of strikes for which relevant quotations are not available, values are calculated by interpolation using a statistical approach known as the “Natural Cubic Spline.” Following quotation identification, the variance (volatility squared) is determined separately for near and mid-month expiry.
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 path breaking work, the trio won the 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; other underlying price(s) may be considered
r= Interest rate (risk-free)
K= Strike price
N= an ordinary/normal distribution
t= time to maturity