Can you measure market fear?
March 28, 2011
Donald MacKenzie is again in the news. A recent article by Gillian Tett draws on MacKenzie’s work to make sense of the recent success of a sophisticated financial instrument. (Thanks to Martha Poon, illustrious ex-blogger, for the lead.)
Tett’s article asks fundamental questions about the recent success of the Vix index, a proprietary product of the Chicago Board Options Exchange.
In recent days, the level of the Vix, which measures the implied volatility of S&P 500 options, jumped to 31, before falling back to below 20 yesterday. But what is more noteworthy is that trading in this index – dubbed the “fear gauge” – has exploded as investors try to speculate on volatility or protect themselves.
The Vix, which is seven years old and has become a moneymaker for the Exchange, may soon be licensed for individual stocks. So: in addition to a “fear gauge” for the entire market, a fear gauge for Apple, a fear gauge for IBM, and so on. But is that a good thing? The question is a classic one for the social studies of finance. And as Tett rightly points out, the benefits of having an extra instrument need to be weighted against the potential reactivity:
In theory, this could potentially be very beneficial for the market. After all, the more liquidity that exists in any product, the more accurate prices are likely to be (…) But as sociologist Donald Mackenzie points out in his book An Engine Not a Camera, when new financial measures and models emerge, they do not simply offer a “snapshot” of activity, they can drive behaviour and change it too (…)
The potential problem is indeed intriguing. Banks have already began to integrate the Vix index in other products such as exchange traded notes. As Tett puts it, “does the existence of another hedging tool smooth adjustments or can a ‘fear’ gauge create more fear?”
Can it indeed? The question provides sociologist of finance with an excellent opportunity to explore the ways in which it can do so — and what to do about it.
Counter-performativity and resonance
One possibility is that the index could prove to be counter-performative. It is a complex measure of an invisible magnitude, “implied volatility.” As the index is increasingly diffused, the diffusion could undermine the premises on which the index rests.
Another disaster scenario is one in which traders get their volatility estimates wrong. If, for instance, traders miss a key factor and thereby underestimate future volatility, their measure of implied volatility will be mistaken. The Vix will still capture “implied” volatility. But that would just magnify the traders’ mistake, and hide it behind a number. And because the Vix is increasingly integrated into other products, the price of equities could easily start dropping. This situation of “resonance” is what David Stark and I explore in our recent paper.
As the Vix becomes a modern deity — more and more encrusted into products, and an increasingly fat cash cow at the CBOE, the innocent gauge will give employment to more and more people. Extra regulators will be needed to keep an eye for spurious increases in the Vix that might percolate into stock prices, government bonds and even house prices. In the private sector, options arbitrageurs in hedge funds will revere the name of Robert Whaley, the academic that brought the index to life. Arbs will be best placed to exploit mispricings in the price of volatility, and their job of master guardians of the fear gauge will become ever more interesting, lucrative — and unpopular.