What is volatility?
Volatility measures the frequency and magnitude of price movements, both up and down, that a financial instrument, sich as stocks or options, experiences over a certain period of time. The more dramatic the price swings in that instrument, the higher the level of volatility.
Volatility can be measured using actual historical price changes (realized volatility) or it can be a measure of expected future volatility that is implied by option prices.
Volatility Index, more commonly known as the VIX is an index that measures anticipated volatility in stocks over the next 30 days. It does so by looking at activity in the market for puts and calls — derivatives that allow someone to bet on the direction of a particular stock or index over a given set of time in the future.
The VIX Index is a measure of expected future volatility. The Cboe Volatility Index® (VIX® Index) is a leading measure of market expectations of near-term volatility conveyed by S&P 500 Index® (SPX) option prices. Since its introduction in 1993, the VIX® Index has been considered by many to be the barometer of investor sentiment and market volatility. It gauges market risk based on investor sentiment about stocks listed on the S&P 500.
The lower the VIX, the lower the expected volatility, and vice versa.
The VIX is a measure of the implied volatility from option prices on the stock market.It has been dubbed the “fear gauge” by financial journalists for its famed ability to track market sentiment.
Mis-pricing of Volatility. One flaw with the Black-Scholes pricing model is the assumption that Volatility is known and fixed. Volatility in itself is volatile.
If you think Volatility will rise, you should buy options. If you think Volatility will fall, you should sell options.
The VIX was like the secret sauce that livened up an ordinary dish. The VIX was able to capture the way that risk appetite fluctuated in the financial system. Risk-taking depends on leverage, and if the financial system as a whole goes through a period of ample funding liquidity, even thinly capitalised banks can borrow on easy terms. Since banks borrow in order to lend, easier borrowing conditions translate into easier lending conditions, reinforcing the already easy financial conditions.
By the nature of the interactions between liquidity conditions and leverage, the boom phase rides an apparent virtuous circle of greater leverage and easier liquidity. The VIX index was capable of capturing such shifts in sentiment.
U.S. Dollar’s Role in the Global Economy
The U.S. Dollar is a better gauge of risk in the global financial system than the so-called “Fear Gauge” – the CBOE Volatility Index (VIX). As long the U.S. Dollar remains stable then the financial markets should remain calm. But if the U.S. Dollar rises, it creates risks to the global economy that are not captured by the VIX index.
To understand the role of the U.S. dollar in the global economy since WWII, the dollar has been at the center of the global economy serving as the “reserve” currency. Reserve currency status is both a burden and a privilege. It means that most currencies, commodities and debt are priced in U.S. dollars. It also serves as a reference currency for the majority of global trade. For a country, company or individual that does not hold U.S. Dollars they must first buy dollars before they can buy the raw materials needed to produce their product.