The world did not end in August, after all. The money market survived, as did the hedge fund industry. There were no big and dramatic failures, just a few rescues. Stock markets were not much changed from the beginning to the end of the month.
But, the month-to-month stability in the equity markets hid something truly extraordinary. The Vix—or volatility index—at the Chicago Board Options Exchange (CBOE), experienced a dramatic jump to levels last seen during, well, the history-making, very-much-real crises.
Having more or less consistently strolled along at a level of around 12-15 for the past couple of years, the Vix—which represents the weighted average of the implied volatilities derived from a bunch of one-month options on the S&P 500—began to shoot for 20 in July, and rose past 30 on 15 August, having achieved a stratospheric intra-day high of 38. As stock markets rebounded, the Vix fell swiftly, stabilizing at around 20.
August 2007 now stands as the fifth highest recording for the Vix since CBOE introduced the index in 1993. And, this dramatic burst in implied volatility must have had outlandish effects on some punters’ portfolios. Those who were “long volatility”—net purchasers of options—would have reaped fantastic mark-to-market rewards. Those who were short volatility—net sellers of options—would have, in contrast, suffered untold misery.
Imagine a six-month put option with the following parameters: 15% volatility, 5% interest rate, $100 (about Rs4,100) strike price, $100 current spot price. You would pay approximately $3.05 for the contract. If after one month implied volatility doubles to 30%, the option will be worth $6.65, a 120% return. If the market drops by 5%, the value would rise to $9.00, a 195% return. The counterparty, of course, would have lost just as much, before taking any hedges into account. Stupendous gains
The breathtaking moves in the Vix have also noticeably affected the fortunes of those investing directly in Vix options. In early July (with the Vix quoting close to 17), one could very economically bet through a call option that the Vix would be above 18 by 22 August, when it actually closed at 23. With the index having climbed all the way to 38 in the interim, mark-to-market gains would have been quite stupendous.
So, while subprime mortgages, complex credit derivatives and funky quant strategies have been highlighted as the stars of the latest tumultuous period to have afflicted the financial arena, the real drama may have taken place elsewhere. When the dust settles, it may seem that the only truly crisis-calibre event took place in the market for implied volatility.