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Financial news services have begun reporting the VIX with increasing regularity. This "new" barometer of investor fear - the Chicago Board Options Exchange (CBOE) Market Volatility Index - is claimed to have reached unprecedented levels and is now, in fact, causing stock market volatility. ' While such misconceptions will, undoubtedly, continue to flow, the purpose of this article is to help stem the tide of investor fear by explaining what VIX is and is not, why it was created, what causes it to move, and why it should be viewed as an important piece of market information for investors. Among the lessons to be learned are that the VIX is not new, is not at unprecedented levels, and does not cause market volatility.
THE VIX
The VIX is an index, like the Dow Jones Industrial Average (DJIA), that is computed on a real-time basis throughout each trading day. The only meaningful difference between the VIX and DJIA is that the VIX measures volatility and the DJIA measures price. The VIX was introduced in 1993 with two purposes in mind. First, it was intended to provide a benchmark of expected short-term market volatility. To facilitate comparisons of the then-current VIX level with historical levels, minute-by-minute values were computed using index option prices dating back to the beginning of January 1986. This was particularly important because documenting the level of market anxiety during the worst stock market crash since the Great Depression - the October 1987 Crash - would provide useful benchmark information in assessing the degree of market turbulence subsequently experienced. Second, VIX was intended to provide an index upon which futures and options contracts on volatility could be written. The social benefits of trading volatility have long been recognized. The Chicago Board Options Exchange launched trading of VIX futures contracts in May 2004 and VIX option contracts in February 2006.
It is important to emphasize that the VIX is forward looking; that is, it measures volatility that investors expect to see. It is not a backward-looking index to measure volatility that has been recently realized, as some commentators sometimes suggest. Conceptually, the VIX is like a bond's yield to maturity. Yield to maturity is the discount rate that equates a...