The Chicago Board Options Exchange’s Volatility Index, also known as the VIX, is designed to produce a measure of constant, 30-day expected (implied) volatility of the S&P 500 equity market. It does so by aggregating a range of put and call option prices into a single number.
Also known as the ‘fear index’, the VIX spiked in 2008 due to the GFC. Since then, it has followed a declining trend, apart from some event-specific spikes. Between January 2013 and December 2017, the VIX averaged 14.8, below its pre-GFC average of 18.9. Furthermore, in May 2017 the ‘fear index’ closed at its lowest level since December 1993.
One mechanism through which expansionary monetary policy could have reduced volatility following the GFC is by lowering bond yields. As Treasury yields fall, the risk-free rate of return declines, and investors look elsewhere for returns. One way to do this is to write – or sell – options. Writing options generates premium and is a manifestation of the search for income in a low yield environment. As incrementally more options are written, there is an increased supply of implied volatility to the market, pushing it and the VIX lower.
It is important to note that for much of the time the VIX lies below its long-run average; implied volatility is skewed to the right. In other words, large spikes in volatility caused by tensions such as the first Iraq war in 1990 and 9/11 in 2001 raise the long-run average. In the absence of such tensions, implied volatility is below its long-run average for much of the time.
One way to account for this is to look at the median value of the VIX. Since 1990, the VIX has closed below its pre-GFC average 56.1% of the time while it has closed below its pre-GFC median value 49.6% of the time. The median value of the VIX in 2023 has been slightly below its pre-GFC median level.
That expansionary monetary policy reduced implied volatility following the GFC raises an interesting question in the current context: will the return to a more normal policy environment lead to a rise in implied volatility?
Since QE had a larger impact on volatility than conventional monetary policy in the US, the speed at which the Fed reduces its balance sheet may be more important for future volatility than the level of interest rates. This could provide an explanation as to why implied volatility has remained below its pre-GFC average and median so far in 2023, despite interest rates being increased to pre-GFC levels. The moderation in the Fed’s balance sheet has been milder by comparison.
It is difficult to assess the possible impact of a return to conventional monetary policy without holding an opinion on the level at which interest rates will eventually settle in the US, and the extent to which the Fed will reduce its balance sheet. Nonetheless, a possible rise in implied volatility could be an important consequence.
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