Thursday, July 19, 2012

VIX near lows shows mispricing of equity risk

Take a look at this chart of the VIX index (the S&P500 implied volatility index). This is not your standard "stochastic" process. In the last 5 years the index has maintained a definite floor somewhere around 15. VIX is currently at 15.45. Risk pricing in US equities is once again showing lack of caution.

VIX

To put it another way let's compare VIX to IG CDX (investment grade CDS index). Unlike VIX which is measuring implied volatilities of options, CDX is an indicator of CDS protection premium (spreads) on the bonds of many of the same US companies. This in effect compares the risk pricing for equities with that of credit. The scatter plot below shows VIX vs. IG CDX levels since 2009. Based on this dislocation, equity implied volatility looks cheap. Certainly being short volatility in this environment could be a serious mistake.

VIX vs IG CDX


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