The VIX: The only thing to fear is the lack of fear itself

The VIX has been called the fear index.  That is, it is a measure of the uncertainty and risk that investors see over the near future (specifically, the next 30 days).  Constructed from options on S&P500 index futures, the VIX is technically a gauge of what is called implied volatility. (For a definition, see the brief note at the end of this post.)

The technicalities are not all that important, as the VIX and similar options-based measures of implied volatility (like the DJIA Volatility Index shown with the VIX in the chart below) track financial conditions pretty well. When implied volatility is low, conditions are relatively accommodative; when it is high, they are restrictive.  Today, volatility is unusually low. 

VIX and DJIA Volatility Index

Source: CBOE. FRED codes are VXDCLS (DJIA) and VIXCLS (VIX), respectively.   

Source: CBOE. FRED codes are VXDCLS (DJIA) and VIXCLS (VIX), respectively.

But there are people out there who are worried. They worry because the level of the VIX today, around 11 percent, is roughly the same as it was just before the financial crisis. At the peak of the crisis, the VIX was over 70.  People are concerned because they think that this unusually low volatility is somehow breeding risk.

This concern may sound perverse: why would low volatility be associated with high risk?  The logic goes like this. When implied volatility is high, investors are cautious because they anticipate a great deal of risk. Conversely, when implied volatility is low, investors are confident that the risk of big asset price changes is low. That makes them willing to take greater risk – to pay a higher price for small expected gains – because they see little downside.  We call that kind of risk-taking “reaching for yield.”

The concern is that low volatility makes investors complacent about risk. For example, according to the minutes of the June 18 FOMC meeting: “…low implied volatility in equity, currency, and fixed-income markets as well as signs of increased risk-taking were viewed by some participants as an indication that market participants were not factoring in sufficient uncertainty about the path of the economy and monetary policy.” When investors underestimate market risks, the prices of risky assets rise to levels that are unwarranted by fundamentals. Lofty asset prices can plummet when events prompt investors to reassess risk. When that happens, both actual and expected volatility typically surge, adding to investor caution.

Indeed, many observers now link the low level of implied volatility in the period before 2007 with the systemic risk-taking that fed the financial crisis of 2007-2009. Consider the following simple example: imagine that financial institutions target a certain level of risk in their portfolio of assets. Measures of portfolio risk – like the widely used “Value at Risk” (VaR) gauge – are positively related to volatility. Consequently, when intermediaries expect volatility to be unusually low, maintaining the targeted VaR requires that they add to the riskiness of their portfolios.  They can do this by increasing leverage, extending maturity transformation, and purchasing assets with a higher probability of default, among other things. When volatility unexpectedly rises – as it did in the financial crisis – these intermediaries try to “de-risk” their portfolios. That means reducing leverage, reducing maturity transformation and selling high-risk assets. Importantly, if everyone does this in a synchronized fashion, as they are wont to do, it can trigger a fire sale and a loss of capital in the financial system. This pro-cyclical behavior is very destabilizing.

Both investors and policymakers now associate the periods of very low volatility with “reaching for yield.” For example, in her June 18 press conference, Federal Reserve Chair Janet Yellen linked them directly: “The FOMC has no target for what the right level of volatility should be. But to the extent that low levels of volatility may induce risk-taking behavior that, for example, entails excessive buildup in leverage or maturity extension, things that can pose risk to financial stability later on, that is a concern to me and to the Committee.”

As Chairman Yellen’s comments highlight, the Fed doesn’t claim to know the Goldilocks level of volatility, nor does it aim for some level it thinks is just right. Indeed, no particular level of expected volatility will be optimal at all times. But the Fed is aware that its efforts to stimulate the U.S. economy by keeping interest rates near zero since 2008 work partly through depressing expected asset price volatility and encouraging investors to take more risk. This policy-induced risk-taking improves financial conditions and supports private spending. It can even reduce apparent risk temporarily by lowering volatility.

The crucial question for policymakers and investors alike is when do these policy incentives go too far? When does the Fed’s low-volatility cure for the economy create risks of financial instability sufficient to offset its benefits?

The VIX can’t answer that question, but it is a useful warning about complacency. And the warning light is on.

Technical note: Option-pricing models (like the classic Black-Scholes model) deliver a measure of future expected risk – called implied volatility because it is implied by the model – from the risk-free interest rate, the price of the underlying asset, and the option’s key attributes: namely, its market price, strike price, and maturity. The model-implied volatility is the expected annualized standard deviation of the price of the underlying asset.