S&P Dow Jones Indices has put out a paper offering market participants without patience for “academic rigor” an accessible guide to the so-called “Fear Index,” the VIX, calculated from the prices of a specific basket of S&P options.

The contributors to the paper are: Tim Edwards, S&P Global senior director, Index Investment Strategy, and Hamish Preston, Senior associate at IIS. They say that VIX is in essence “a crowd-sourced estimate for the degree to which the market is uncertain about the future.” So if the market participants are rational, VIX will have some predictive value, predicting not the direction of prices but the amount of movement.

For Practitioners

Take any level below 12 to be “low” and any level above 20 to be “high.” Call the territory in between “normal.” Edwards and Preston ask: has the level of VIX so understood had any predictive value regarding future volatility? One finds that the index accurately predicts what the volatility of the S&P 500 will be in the next 30 day period. A high VIX predicts high prices changes and vice versa.

But VIX levels won’t correspond directly to the volatility observed 30 days later. A VIX level of 25% does not mean that markets anticipate 25% volatility. Given the hedging value of VIX, there is typically an excess demand for the options involved (excess from the point-of-view of a pure anticipation hypothesis) and this results in a premium. VIX today slightly overstates the level of volatility that will be experienced in the month to come.

Edwards and Preston illustrate the “historical extent to which VIX has overestimated subsequent volatility” using a 252 day trading day trailing average of VIX, superimposed on the trailing average of the S&P 500 volatility over the next 30 days from 1990 through 2016. The only time when the two lines exactly corresponded was in the big run-up of volatility in 2007-08. Until then, and again after that, they had diverged. The average distance between the two lines, the overestimation, is between 4 and 5%.