Saturday, March 20, 2010

Fool Me Once Shame on Me…Fool Me Twice Shame on?

This is the graph of the volatility index (ViX), commonly known in Wall St. as the “fear gauge.”

The ViX measures the implied volatility of the S&P 500 listed options. Options give the holder the right (but not the obligation) to buy/sell the underlying security for an agreed-upon price during a fixed amount of time. The index moves in opposite directions in market gyrations: that is, in times of excessive uncertainty the ViX declines, while during times of stability it declines. Currently, the ViX sits around 18. At the height of the financial crisis it reached a record high of 80.86. This manifestation gives the impression that risk has receded and markets are tamer. As can be noted from the graph, the index is at a level experienced prior the financial fallout. It take no rocket scientist to figure out that the massive manipulation of the market—by way of fiscal and monetary policy—has left the ViX number practically misleading. It is a backward looking indicator, meaning it merely represents what has happened in the past. It says nothing about the future.

Bear in mind also that the Index is priced using the Black-Scholes option pricing model, which at this time we would expect to underestimates risk. Why? Simple: because the model assumes volatility is constant (i.e. it won’t change) and financial markets reflect behavior that can be statistically assessed by the normal distribution curve. Acceptance of these assumptions are at the heart of why many of the brightest minds were not able to see the oncoming train wreck of 2008-2009 and it is why many believe we have passed the worst. Yet, the market is merely stirring towards the great collapse that is ahead of us. This is not an ideological point, but rather how the economic laws of cause and effect function.

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