Reward and Risk!! - The India Volatility Index (VIX)

Risk and Reward go hand in hand. One need not be an ‘MBA’ to discover that. However, what exactly is risk? Talking to a friend who’s been actively trading in the equities (and now FnO) markets for the past few years, I realized few people have an answer to what exactly risk is or how to quantify it. After a couple of courses on financial management and a few readings of some sections of Brearly and Myers later, I have a bit more clear answers to the question on risk than I had a year back. However, what if i hadnt joined XLRI or had not known about the greatness of Mr Brearly and Mr Myers?

If everyone knows returns and risk go hand in hand and there is no point talking about one in isolation with the other, why is it that everyone just talks about the rise and fall of sensex (or any other index depending on the country you are; or all the major global indices if you are an MBA student) without giving heed to how volatile (or risky) the movements have been? I happened to meet an old friend at CCD last evening, for the first time after he has completed MBA from a global Indian Bschool (which now also ranks pretty high in FTs list of global Bschools) and he said the risk is also included in the index as the underlying valuations which form the basis of an index take risk into account. While he’s right in a way, the question is not on the valuation or levels of the index, but on the overall returns vis-à-vis the volatility (risk) of the index itself.

NSE, the premier Indian stock exchange seems to have opened its eyes to this fact and thus the recent introduction of VIX, India’s own Volatility Index. So, what exactly is this VIX? In the words of NSE, “Volatility Index is a measure of market’s expectation of volatility over the near term”. The Indian markets have not just been amongst the best performing over the last few years in terms of the returns, they have also been pretty open to changes and in the introduction of new products. We have come quite a way since the inception of futures and options less than 10 years ago. The volumes have been on the rise, the mini contracts have been introduced and we have also been listed on other exchanges. So, it came as no surprise when NSE decided to introduce the VIX.

I’m staying away from explaining what VIX is, how is it calculated and what is its interpretation as I am in process of understanding the interpretations myself. However, in short, VIX is a measure of the implied volatility in the near term (30 days) calculated using the near and mid month option prices. The calculation methodology is exactly same as used by CBOE. However, the VIX figures in their brief history raise a few questions.

The VIX in India fell 16% on 7^th Apr, went up 21% a couple of days later and again fell by 20% the very next day to rise 10% again a day later. If the VIX keeps behaving the same way, one would have to take a call on the utility of the index or NSE would have to figure out ways to find better methods than just simply copying the CBOE. Also, no wise investor would trade into such a ‘volatile’ ‘volatility’ index. CBOE introduced the VIX in 1993 and it took them 11 years to start trading into the VIX. Are we ready for the index in its current form and calculation methodology? Is the options market liquid enough (especially the mid month contracts) to give a meaningful figure? NSE has also said “There is no intention to introduce tradable products based on the India VIX in the immediate future. Once market participants are comfortable, India VIX futures and options contracts can be introduced in the Indian markets, based on regulatory approvals, to enable investors to buy and sell volatility and take positions based on the movement of India VIX”.

My take would be India VIX would not require 11 years (may be not even half that number) to start trading. But the options market would have to become more liquid or the methodology redefined (or maybe even both) before we find any meaning in the index.

On more futuristic thoughts, I’d like to believe we would also see the exotic volatility indices, the ones that measure the volatility of the volatility indices :) Happy investing!!

- Saurabh Bagrodia
Business Management, 2007-09

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