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Explication of the CBOE VIX.
The Chicago Board Options Exchange's market volatility index (the VIX) is called the "investor fear gauge." The name fits. The index is set by investors and expresses their consensus view about expected future stock market volatility. The higher the VIX, the greater the fear.
To see why we need to know how the VIX is constructed. To see how VIX works, we need to examine its history and its relation to stock market movements.
CONSTRUCTION OF THE VIX
VIX is an implied volatility in the parlance of the securities industry It is similar in spirit to a bond's yield to maturity. To compute a bond's yield to maturity, we search numerically for the discount rate that equates the present value of the bond's promised coupon payments and principal repayment to the bond's current price. What permits the computation is the fact that, although the bond valuation model includes a number of terms (or parameters), only one is unknown: yield to maturity. The amount and the timing of the coupon payments and principal repayment are known.
Equating the market price of a bond to its model value and solving for yield, therefore, means that the computed yield to maturity is an implied (by the bond price) yield to maturity. It is the market's "best" assessment of the expected rate of return over the remaining Life of the bond.
Like a bond, a stock index option has a valuation model. And, like the bond valuation model, the stock index option valuation model has a number of parameters, all but one of them known or able to be estimated with a high degree of accuracy The unknown parameter is the index's expected future volatility.
By equating the market price of an index option to its model value and solving for volatility, we identify the implied (by the option price) volatility. This implied volatility is the market's "best" assessment of the expected volatility of the underlying stock index over the remaining life of the option. Since VIX is based on S&P 100 index (or OEX) option prices, VIX represents a market consensus view of the expected volatility of the S&P 100 index.
To be more precise, VIX is computed on a minute-by-minute basis...