VIX's Fall Just a Return to the Norm
By Aaron L. Task
Senior Writer
03/18/2002 02:47 PM EST
The VIX continues to vex.
Last Wednesday's story about the CBOE Market Volatility Index's lack of forecasting abilities generated a lot of thought-provoking feedback from readers. (So, I suspect, will a similarly themed piece in the current issue of Barron's.)
But lost in the discussion (more on the feedback in a moment) is that, for all the concern about how low the VIX has gotten, it is trading at historically high levels.
"During the bubble we had an astronomically high volatility era that's coming to an end," Diane Garnick, global investment strategist at State Street Global Advisors in Boston, commented on Friday. "Investors have become used to high volatility, but in reality, we're approaching the long-term trend [for the VIX] , which tends to be between 15 and 20."
During 1999 and 2000, the VIX traded mainly in the 30s and 40s, but it wasn't until 1997 that it broke above 20 on a sustained basis, Garnick recalled. In the early 1990s, the volatility index mainly traded in a range of 10 to 15, as RealMoney.com contributor Tony Saliba recently noted.
Two things make volatility high: recession and bubbles, Garnick continued. With the tech bubble having ended and the recession apparently over, the "volatility bubble" has burst, she said, suggesting the VIX will likely settle into a range between 18 and 25. Volatility is "mean reverting," she said, but it will not go all the way back to its prior 15 to 20 range because of the increased number of higher volatility (i.e., tech) stocks that are now components of the S&P 100 and S&P 500.
The VIX was up 2% to 21.19 at midday today, rising as major averages surrendered early gains. But calling the VIX low at those levels is akin to saying the Nasdaq Composite is "cheap" at around 1870 just because it once traded at more than 5000. That is, it presumes extreme levels as being normal.
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The VIX Debate, Continued
In reference to the aforementioned reader feedback, many emailers sought to explain the VIX's relatively subdued levels (relative to very recent history, of course).
One reader noted that the divergent performance of the Dow Jones Industrial Average, which was up 5.8% year to date heading into today, and the Nasdaq, down 4.2%, might explain the VIX's quietude. "An indicator based on fear would understandably not be too effective as many people who held or hold S&P/Dow-type issues were not particularly scared," he wrote.
A more academic rationale comes from a recent report by Credit Suisse First Boston's U.S. economic team, which noted the dampening effect that increased usage of convertible bonds has had on stock market volatility.
"Think about volatility as a commodity, which reacts to demand and supply imbalances just like the price of oranges," the report states. "Increased convertible bond issuance [i.e., more oranges] has meant increased call-option issuance, and therefore an increased supply of stock option volatility. Hence, the dampening effect on the level [or price] of volatility," as measured by the VIX.
In 2001, more than $104 billion of convertible bonds were issued, almost double the previous record set in 2000, CSFB reported. If that level were treated entirely as debt, net corporate bond issuance was 40% larger than the roughly $250 billion of "regular" corporate bonds sold, the report noted. If the convertibles were treated entirely as stock, corporations would have added $32 billion worth of equity in 2001 rather than retiring $72 billion via buybacks.
Those figures are theoretical, but the point is that when stock prices fall, convertible issues that "have been hitherto treated as 'equitylike' can suddenly look a whole lot more like debt [and] balance sheet leverage leaps," CSFB concluded. "The irony is that while the issuance of convertible bonds is dampening stock option volatility, it's one of the factors adding to the riskiness of corporate America's capital structure."
It's the kind of irony with which shareholders of firms such as Enron, Tyco International (TYC:NYSE - news - commentary - research - analysis), Lucent (LU:NYSE - news - commentary - research - analysis), Calpine (CPN:NYSE - news - commentary - research - analysis), and WorldCom (WCOM:Nasdaq - news - commentary - research - analysis) et al. are all too familiar. |
