Volatility Index

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Context:

• India VIX, a measure of expected market volatility in the near future, surged past 21 on May 14.
• This increase indicates that traders and investors are now more concerned about potential market fluctuations than they were 15 days ago. The current anxiety among market participants is primarily due to the uncertainty surrounding the outcome of the ongoing Lok Sabha elections.

Background: What is volatility?

• Volatility refers to extreme price fluctuations in the market. While volatile markets can be highly profitable and attract traders, they also come with increased risk.
• For example, the potential for sharp price drops can deter some traders from participating in very volatile markets due to the high risk of losses.
• The VIX, or Volatility Index, provides insight into market volatility. It helps investors gauge the level of fear, risk, or stress in the market.
• Volatility, or how fast prices change, is often seen as a way to gauge market sentiment, and in particular the degree of fear among market participants.
• Understanding volatility compared to a stable market helps investors make better investment decisions.
• Traders use the VIX to leverage their understanding of market volatility to their advantage.

What is the Volatility Index?

• The Volatility Index, also known as VIX or the Fear Index, measures the market’s expectation of near-term volatility.
• Volatility refers to the rate and magnitude of changes in prices, often considered synonymous with risk in finance.
• During periods of high market volatility, prices move sharply up or down, causing the VIX to rise. When volatility decreases, the VIX falls.
• The VIX represents the expected fluctuation of an underlying index over the near term, expressed as annualized volatility in percentage terms (e.g., 20%). This is calculated using the order book of options on the underlying index.
• The VIX generally rises when stocks fall, and declines when stocks rise.

Genesis and Evolution

• The Chicago Board Options Exchange (CBOE) introduced the first volatility index for the US markets in 1993, based on S&P 100 Index option prices.
• In 2003, the methodology was updated to use S&P 500 Index options. Since then, the VIX has become a key indicator of market sentiment about volatility. Investors use it to assess market conditions and make informed investment decisions.
• The CBOE Volatility Index (VIX) signals the level of fear or stress in the stock market—using the S&P 500 index as a proxy for the broad market—and hence is widely known as the “Fear Index.”

What is India VIX?

• India VIX is a volatility index calculated by the National Stock Exchange based on NIFTY Options.
• It uses the best bid-ask quotes of near and next-month NIFTY options contracts traded in the NSE’s F&O segment.
• India VIX reflects investors’ expectations of market volatility over the next 30 days.
• Higher India VIX values indicate higher expected volatility, while lower values suggest lower volatility.
• 'VIX' is a trademark of the CBOE. The NSE uses this mark for India VIX under a license from Standard & Poor’s, granted with CBOE’s permission.

NIFTY 50 The NIFTY 50 is a benchmark Indian stock market index that represents the weighted average of 50 of the largest Indian companies listed on the National Stock Exchange. Nifty 50 is owned and managed by NSE Indices, which is a wholly owned subsidiary of the NSE Strategic Investment Corporation Limited.

Why has India VIX surged?

• In May, India VIX has jumped by around 53%, surpassing 20.
• On 14^th May, it reached a high of 21.88 during the afternoon.
• The increased volatility in the benchmark equity indices is due to concerns over the results of the ongoing elections, set to be announced on June 4.
• Market participants are worried that a lower voter turnout might affect the BJP’s seat count.
• Additionally, heavy selling by foreign portfolio investors, who sold off Rs 18,375 crore of Indian equities by May 13, has contributed to the market decline.
• A major domestic event like the Lok Sabha elections brings a certain level of uncertainty about the outcome. Just as in the 2014 and 2019 elections, there is a similar level of fear or uncertainty regarding the results.
• A high India VIX value indicates that market participants are becoming more cautious and expecting increased volatility as the event progresses.
• India VIX reflects expected market volatility and usually rises before significant events like elections that could significantly impact the market's direction. As expectations about the election outcome change, the VIX also rises.
• However, this time, while the VIX has increased, it has done so more slowly compared to previous elections because there was less uncertainty about the outcome when the elections began.

PRACTICE QUESTION Q. Consider the following statements about India VIX: 1.India VIX is calculated by the National Stock Exchange (NSE) based on NIFTY Options. 2.India VIX reflects investors' expectations of market volatility over the next 90 days. 3.India VIX tends to rise during periods of high market volatility and uncertainty, such as during elections. 4.The calculation of India VIX includes the best bid-ask quotes of near and next-month NIFTY options contracts. Which of the above statements are correct? a) 1 and 2 only b) 1, 3, and 4 only c) 2, 3, and 4 only d) 1, 2, 3, and 4 Answer: b) 1, 3, and 4 only Explanation: Correct: India VIX is indeed calculated by the National Stock Exchange (NSE) based on NIFTY Options. Incorrect: India VIX reflects investors' expectations of market volatility over the next 30 days, not 90 days. Correct: India VIX tends to rise during periods of high market volatility and uncertainty, such as during elections. Correct: The calculation of India VIX includes the best bid-ask quotes of near and next-month NIFTY options contracts.

SOURCE: THE INDIAN EXPRESS