FAIRBAIRN CAPITAL INVESTMENT INTELLIGENCE Investment 101 September 2009 Gauging Investor Fear In 1993, the Chicago Board of Options Exchange created the CBOE Volatility Index® - more commonly known as the VIX® - which quickly became known as the ‘fear gauge.’ Today it is an important barometer of the investment climate, and during the darkest days of the credit crisis, became one of the most-watched global indicators. The main purpose of the VIX is to derive the implied volatility of the market over the next 30 days. The higher the index, the greater the implied volatility in either direction of the market (up or down). However, traditionally, a higher value is interpreted as pointing to falling equity markets (hence the ‘fear gauge’ name). There is no neutral reading for these fear gauges, but traditionally a VIX reading above 30 has signified a ‘fearful’ market. During the worst days of the credit crisis, the VIX shot up to levels of 80. Based on how the VIX is interpreted (annualised implied volatility, for those interested in jargon), a reading of 80 means the (annualised) expected volatility over the next 30 day period is 80%. The calculation and information gathering pertaining to the VIX is quite complex, but basically it is calculated using current pricing of options based on from the S&P 500 index. (An option is a financial derivative, a contract sold by the option writer to the option holder, giving the latter the right, but not the obligation, to buy (“call”) or sell (“put”) a specific security (such as a share) at an specified price (“the strike price”) before or on a specified date. It is called a ‘derivative’, as the value of the option is derived from the value of the underlying security). Options volatility (put and call) is used to construct the index as investors expecting a change in share prices will use options to hedge their current positions. The greater the fear of future price changes, the more costly the options required to hedge against such changes (think of it in insuarance terms: the greater the perceived risk, the greater the premium to insure against the risk). The VIX is a tradable index, meaning investors can buy the index itself (rather than the options it follows) to protect against future price movements, or bet on volatility. Because the S&P 500 is seen as an indicator for global risk appetite or aversion, the VIX is similarly seen as a global indicator. South Africa also has a fear gauge, albeit a much younger one -the South African Volatility Index (SAVI). The SAVI is similar to the VIX, but gives a three-month forecast instead of a one-month forecast. It is derived from options prices based on the JSE’s Top 40 index of shares. The SAVI is not tradable yet, so its main purpose is to measure volatility and the implied future movement in share prices. Both the VIX and the SAVI are available on a daily basis. www.fairbairncapital.com Please note that while care has been taken to ensure that the information provided in this article is correct, it represents an overview of the topic under discussion and as such does not constitute advice. We suggest that you contact your professional adviser before taking any decisions based on the information herein. Fairbairn Capital is an elite service offering brought to you by Old Mutual Investment Services (Pty) Ltd and Old Mutual Life Assurance Company (South Africa) Ltd, Licensed Financial Service Providers. Viewing the VIX and S&P 500 index together on the graph below, illustrates why the fear gauge is so closely- watched: 80 1400 70 60 1200 50 40 1000 30 800 20 10 600 Jan-08 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 VIX (LHS) S&P 500 (RHS) Source: Inet, FCII During the first eight months of 2008, the VIX averaged 23, but was quite volatile due to growing concerns over the subprime debt. But following the collapse of Lehman Brothers in September, the index spiked to record levels and hit a high of 80.86 on the 20th of November. Since then, the VIX has gradually moved back to its pre-Lehman levels, as calm returned to markets, especially after March of this year. As can be seen on the graph, the S&P 500 generally moves in the opposite direction as the VIX, with spikes in the VIX reflected in sharp plunges on the S&P 500. In South Africa, The SAVI paints a similar picture in relation to the JSE Top 40 Index. 60 55 30000 50 27000 45 24000 40 35 21000 30 18000 25 20 15000 Jan-08 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 SAVI (LHS) FTSE/JSE Top 40 (RHS) Source: Inet, FCII The SAVI spiked to 57.97 on the 27th of October, and again to 57.01 on the 20th of November, the day the Top 40 index reached its low. Since then, as fear has subsided, the SAVI gradually moved downwards. Since risk appetite returned to global and local markets in early March, the SAVI has moved down quite substantially. www.fairbairncapital.com Please note that while care has been taken to ensure that the information provided in this article is correct, it represents an overview of the topic under discussion and as such does not constitute advice. We suggest that you contact your professional adviser before taking any decisions based on the information herein. Fairbairn Capital is an elite service offering brought to you by Old Mutual Investment Services (Pty) Ltd and Old Mutual Life Assurance Company (South Africa) Ltd, Licensed Financial Service Providers.
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