Ask Mint | Volatility index helps gauge market mood and design derivative products

Ask Mint | Volatility index helps gauge market mood and design derivative products
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First Published: Mon, Sep 08 2008. 01 12 AM IST

Updated: Mon, Sep 08 2008. 01 12 AM IST
Some people enjoy dancing in the rain but some really hate getting drenched. Some people enjoy the stock market volatility but some get killed by the same volatility. Different people view the same thing differently. Amid so many different perceptions, our friend Johnny just seeks clarity. Recently he heard about something new: the India Volatility Index or India Vix, in short.
Jinny: Hi, Johnny! Today you look happy. What’s the matter?
Johnny: Yes! I feel happy whenever I have something new to ask you. I hope you will answer my queries.
Jinny: Oh sure! What is the new thing you are going to ask me about?
Johnny: Can you tell me what a volatility index is?
Jinny: Volatility denotes the extent to which the value of our investment may be subject to the mood of the market over a given period. A volatility index tells us about the market expectations over the short term, usually a month. It tries to capture the sentiments of the market—whether the market is in a complacent or anxious mood. Volatility is what makes our short-term investments look more dangerous than our long-term investments. John Maynard Keynes famously said that in the long run we are all dead. But that does not mean that in the short run we are absolutely safe. Some investors feel that surviving short-term market volatility is more challenging.
Volatile markets can turn upside down, making our whole investment look like a monkey doing acrobatics. In fact, Keynes himself once said that markets can remain irrational longer than you can remain solvent. So every now and then, we may see investors getting caught on the wrong side of market irrationality. A volatility index captures implied volatility in the market.
Illustration. Jayachandran / Mint
Implied volatility draws its conclusions from the present pricing of options and not from historic volatility figures. It is expressed in terms of a percentage like 20%, 30%, etc. In a range-bound market, where prices are moving gradually, the volatility index remains low. It is believed that when the volatility index is less than 20%, the market is in a complacent mood and is not expecting any catastrophe. A low volatility index is therefore, associated with price rise.
But when the volatility index is greater than 30%, then the market is in the fear zone. A high volatility index is associated with a fall in market prices. In this manner, a volatility index helps investors gauge the mood of the market.
Johnny: It is good that the volatility index is so useful. Now tell me, what is the India volatility index?
Jinny: India Vix is the first volatility index launched in India by the National Stock Exchange. As you might be aware, the Chicago Board of Options Exchange (Cboe) introduced the first volatility index for the US markets in 1993. Cboe Vix uses the Standard and Poor’s 500 Index Options for calculating implied volatility, which is reflected by the changes in pricing of options. India Vix is based on the Nifty 50 Index Option prices. It calculates the percentage of volatility by using a detailed computational methodology which relies on the best bid and offer price of the Nifty 50 index call and put options. If you are interested, I can tell you about computation of volatility index in detail.
Johnny: Thanks, but I don’t want to spoil my mood by doing mathematical calculations now. Tell me, what could the other uses of a volatility index be?
Jinny: Other than gauging the mood of the stock market, a volatility index can also be used to design derivative products in which the volatility index is used as an underlying.
Investors who are averse to volatility can hedge their portfolio by purchasing derivative products based on the volatility index. And investors with a good appetite for volatility can take the risk by selling the same derivatives product. All in all, a volatility index provides a new game of hedging and trading for market participants. But how is hedging through volatility index derivatives different from hedging through single stock or index derivatives? Well, hedging through single stock or index derivatives is like purchasing a comprehensive insurance which covers many risks that you may not be even aware of. But a derivative product based on volatility index keeps its focus narrow—it provides a hedge against only market volatility.
So if the prices of your company’s shares are likely to fall due to poor quarterly results, then purchasing volatility index derivatives may not protect you. The market may remain calm even though your own individual portfolio may be performing badly. This is because a volatility index does not measure the volatility of a single instrument but uses a wide range of different instruments.
So if the prices of your stocks are likely to fall due to poor market sentiments and not due to any company-specific reason, then a volatility index derivative may be your right bet.
Johnny: That’s true, Jinny. Choosing the right bet is what separates winners from losers.
What: Volatility index measures implied volatility in the market over the short term, usually a month. India Vix is the first volatility index launched by the National Stock Exchange.
How: India Vix calculates volatility by computational methodology, which relies on the best bid and offer price of the Nifty 50 index call and put options.
What: Volatility index can also be used for designing derivative products in which the volatility index is used as an underlying asset.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
To read all of Shailaja and Manoj K Singh’s earlier columns, go to www.livemint.com/realsimple
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First Published: Mon, Sep 08 2008. 01 12 AM IST