The CBOE Volatility Index ($VIX), which measures the near-term volatility of $SPX options, fell to a near 10 year low closing at 11.23. Current low volatility figures are indeed puzzling given a tenuous macro and financial backdrop which include: a weak dollar, record current account imbalances, fiscal deficits/record high consumer debt levels, soaring energy prices, a leverage-happy financial community, unfavorable valuations, etc. Of course, the counter-weight that justifies low volatility readings is that the domestic/global economy is awash in liquidity, creating for a cash-rich Corporate America w/ strong balance sheets that in effect provides a cushion against an internal or exogenous shock. While liquidity is abundant and corporate balance sheets have indeed strengthened, I believe that such low volatility numbers do not correctly represent the true acute financial fragility of the global landscape.
Because volatility (premium) has been beaten down in such an orderly fashion for the last 1½ yrs, one has to wonder whether complacency is the only factor that explains these low numbers.
In Sept 2003, the CBOE announced changes to the computation of the $VIX, basing the calculation on all available $SPX options, as opposed to the old method of just eight out-of-the-money $OEX options ($VXO). The new index does not use traditional formulas such as the Black-Scholes model, but rather creates the volatility index directly from the options prices themselves. In comparing the $VIX (new method) and $VXO (old method), the price differential is quite subtle and therefore does not offer much insight toward explaining these decade low numbers.
In addition to these computational changes, volatility futures (ticker: VX) began trading on the CBOE Futures Exchange earlier this year. This is a development I believe is more important toward explaining the steady volatility compression of the past 1½ years. VX contracts have made the strategy of volatility trading much more accessible – where previously, one would have to employ tedious delta-neutral options spreads to buy or sell premium (volatility). The ease of trading futures contracts has provided for a deeper market, with more market participants employing directional bets on volatility – essentially taking the volatility out of volatility as well as providing for a more established trend.
While a high level of complacency is probably the overriding theme toward explaining this steady volatility compression, the effects of new volatility products should be considered in making in assessment on the significance of such low volatility numbers.
--UK
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