## Saturday, January 21, 2006

### A sharp rise in the VIX

Just last friday (14th January 2005), I wrote a blog entry saying that the VIX was very low, and it made a lot of sense to buy protection using put options on the S&P-500 at an implied volatility of 11%.

The VIX just rose and rose after that! [News story about VIX on Friday] The first opening price after that friday was at 12%. On Friday the 20th, it went up to 14.56%. Here's a table of the relevant data. While it's risen sharply, it's still at very low values by historical standards. I think all eyes will be on the VIX on Monday.

What happened!? Global equity markets have certainly become a lot more nervous. I could discern one potentially important piece of new bad news: that high US consumption based on home equity extraction could be coming to an end.

1. I have read a number of reports that predict a pickup in volatility over the course fo 2006. To understand this further, I think we need to be clear on the reasons for such a prolonged period of low vol (End 2004, Whole of 2005). The conventional arguments that you would generally hear for the causes of low vol:
Regime of low/decreasing interest rates-->Investors appetite for yield-->Leading to higher amounts of risk they need to take on -->Resulting in a "herd" kind of behaviour where traders collectively "beat down" volatility by say selling put options.....

My questions are: Is the above line of argument really valid??
Will 2006 see a decrese in the appetite for investors towards risk??

2. I personally don't have a judgment about how the VIX will play out in 2006. I am just a consumer of the VIX. I find the situation with global macroeconomic imbalances to be terrifying. When we add up : the US current account deficit, the US housing market, the fixed investment and real estate stories in China, the broken Chinese financial system, the gigantic reserves accumulation of East Asia: it all adds up to a picture that should scare any reasonable person.

Can low interest rates lead to a quest for yield and artificially depressed implied volatilities? I believe so. I think there isn't enough smart money in the world to take offsetting positions against the pension funds and insurance companies when they are in a quest for yield. E.g. insurance companies (largely in Europe) have taken up gigantic US credit risk exposures.

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