Volatility Index Research Paper

1300 Words6 Pages
The Forecasting Power of the Volatility Index: Evidence from the Indian
Stock Market
Surya Bahadur G. C.
Assistant Professor, School of Business, Pokhara University, Nepal
Email: suryagc@gmail.com
Ranjana Kothari
Assistant Professor, Amity University, Gurgaon, India
Email: rkothari@ggn.amity.edu
Stock market volatility is a measure of risk in investment and it plays a key role in securities pricing and risk management. The paper empirically analyzes the relationship between India
VIX and volatility in Indian stock market. India VIX is a measure of implied volatility which reflects markets’ expectation of future short-term stock market volatility. It is a volatility index based on the index option prices of Nifty. The study
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VIX offers great advantages in terms of trading, hedging and introducing derivative products on this index (Satchell and Knight, 2007). Investors can use volatility index for various purposes. First, it depicts the collective consensus of the market on the expected volatility and being contrarian in nature helps in predicting the direction. Investors therefore could appropriately use this information for taking trading positions. Second, Investors whose portfolios are exposed to risk due to volatility of the market can hedge their portfolios against volatility by taking an off-setting position in VIX futures or options contracts (Banerjee and
Sahadev, 2006). Third, investors could also use the implied volatility information given by the index, in identifying mispriced options (Jian and Tian, 2007). Fourth, short sale positions could expose investors to directional risk. Derivatives on volatility index could help investors in safeguarding their positions and thus avoid systemic risk for the market (Lu et al., 2012).
Fifth, based on the experience gained with the benchmark broad based index, sector
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The CBOE has also introduced volatility derivative products based on the index.
Corrado and Miller (2005) compare the forecast quality of implied volatility indexes to historical volatility, and they find VIX outperforms historical volatility in forecasting future realized volatility. Similar result is found by Zhang (2006), who show that VIX outperforms
GARCH volatility estimated from the S&P 500 index returns. A very important feature of
VIX is that VIX tends to be higher when the stock market drops, for example, VIX was particularly high during the last quarter of 2008, when the stock market tumbled. Whaley
(2009) explains why VIX is a useful “market fear gauge”: when stock market is expected to fall, investors will purchase the S&P 500 put options for portfolio insurance. The more investors demand, the higher the option prices. As option price is a monotonic increasing function of volatility, VIX will increase when the S&P 500 index option prices increase.
According to a recent report by the S&P 500 Corporation, VIX is very useful in forecasting the direction of future market movements, particularly when movement is large. These findings highlight the potential benefits of adding VIX as a new asset class to hedge portfolio

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