Is the VIX Index a Reliable Predictor of Future Realized Volatility?

The VIX, commonly known as the "fear gauge," is a model-free index that serves as a reflection of market volatility expectations for the upcoming 30 days. Essentially, it represents the price of a basket of short-maturity options. The VIX is calculated from the S&P 500 index options' prices, offering a real-time assessment of investors' collective outlook on market volatility. Elevated VIX values often suggest increased perceived risk and uncertainty in the financial markets.

Reference [1] examines whether the VIX functions as a "fear gauge" or a reliable predictor of future realized volatility. The former has a more sentimental or irrational interpretation. On the other hand, the latter suggests that the VIX could be a reasonable estimate of future realized volatility, implying that the investors who trade call and put options on the stock index are primarily guided by rational analyses rather than emotions. The authors pointed out,

Regression analysis concludes that VIX has a connection with the forward volatility, but sentiments drive short-term swings of VIX. In other words, investors should not extract information from the daily changes of VIX but rather look at the general level of the index. Including the binary variables that represent periods of tranquility and turbulence provided more profound insight into the predictive property of VIX during those periods. VIX behaves differently when the market is stable and calm from market turmoil. VIX positively links to the one-month forward volatility when the market is exceptionally volatile. However, if the market is exceptionally stable, this link has a negative relationship, implying that the volatility index is primarily driven by irrational sentiments such as fear in those periods.

In short, the article concluded that

• the VIX is linked to future realized volatility, but in the short term, it is influenced by market sentiment.
• In a stable market, irrational sentiment primarily drives the VIX.
• In a volatile market, it serves as a more accurate predictor of future volatility.

Let us know what you think in the comments below or in the discussion forum.

References

[1]  Askar Koshoev, The Volatility Index: A Hedging Tool or an Object of Speculation?,  Review of Integrative Business and Economics Research, Vol. 13(2), 1-18

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