Empirical (GARCH model) volatility has fallen back into “normal” range, while VIX remains extremely high. That suggests that VIX is too high and needs to come down, barring some untoward shock.

Empirical (Garch Model) vs. Implied (VIX) Volatility on the S&P 500

The virtue of GARCH as opposed to simple standard deviation of return calculation of volatility is that it bootstraps a flat-tailed distribution, pricing volatility much higher in response to big moves out of previous ranges.

The above graph was calculated using daily S&P 500 return data from August 1, 2008 to the present. The result is not much different, though, if we use daily data for the past four years:

To clarify the relationship, the next chart shows a scatter graph of the S&P 500 level during the past four years against VIX (dots, right-hand scale) and empirical GARCH volatility (squiggly line, left-hand scale):

Jan 3, 2005 to Jan 9, 2008: S&P 500 (Horizontal scale) vs. VIX (Dots, Right-hand scale) vs. Empirical Volatility (line, left-hand scale)

It’s clear from the above graph that empirical volatility has collapsed while the S&P remains at the bottom, although implied volatility remains elevated.

It just doesn’t make sense to pay for volatility at these levels. The government is taking a great deal of surprise out of the economy by owning more and more of it, starting with the financial system. Socialism is miserable, but not volatile.

This provides another good argument for highly selective acquisition of quality debt instruments.

This entry was posted on Tuesday, January 13th, 2009 at 4:18 pm and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.