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The Taylor Rule: Ignore Fraud Epidemics and Worship Markets

By       Message William K. Black, J.D., Ph.D.       (Page 3 of 5 pages) Become a premium member to see this article and all articles as one long page.     Permalink

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The VIX is widely followed as an indicator of investor sentiment, although there has long been debate over its efficacy as more financial instruments are derived from it.

"It's still relevant in extremes, but not in a normal functioning market,' Pringle said.

Pringle cited Citi trading strategy research showing tens of billions of dollars' worth of assets under management linked to the VIX through structured notes, which had to be rebalanced to reflect actual market moves. This dampened volatility, he said.

The Citi data showed these VIX-related contracts make up about 34 percent of overall volatility trading on the S&P 500 and as much as 44 percent of the short-term, 2-month volatility.

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The VIX rose nearly 80 percent in three weeks after the Fed hinted in late May at "tapering' its stimulus, albeit from a low starting point. It has since given back almost half the gains.

At levels around 15, it is currently below its average of just over 20, nearly half the 2012 high of 28 and well off the 2011 high of 48 and all-time high of nearly 90.

COMPUTERS DRIVING VOLUMES

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While persuading others of the VIX's flaws is not easy, Pringle said Citi's handling of risk management in equities had been restructured accordingly.

Rather than relying solely on the VIX, Citi traders and clients can turn to the Central Risk Desk, through which a large proportion of its trades are routed.

The computer programs that underpin the desk's activities assess around 60 measures of market stress and timing -- from global risk arbitrage spreads to dividends to repo rates -- to get a better read on sentiment, behavior and deal timing.

Looked through this prism, there is greater risk currently in global markets than the narrower VIX is suggesting.

"Basically every "fear factor' you could possibly get your hands on,' Pringle said. Such a move had helped the bank be more efficient and grab 2 percent of market share in Europe, the Middle East and Africa last year, he said."

Both aspects of these developments render the ECB authors' use of the VIX index unreliable as a variable.  One of the empirical problems that arises when there are strong reasons to fear that its relationship to "implied volatility" has grown is weaker is obvious.  A weak relationship renders the index useless.  But an index that changes over time in its relationship to "implied volatility" causes even greater empirical unreliability if the study looks at any material time period (and the ECB study does).

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Third, there is, therefore, no way of proving whether the techniques the authors used to purportedly decompose the index and obtain a measure of risk aversion by stock market investors actually measure their aversion.  The authors' methodology is inherently a faith-based asserted decomposition of a faith-based VIX index.  We cannot reliably test whether either the VIX index or the decomposition is correct.  As I have explained, the theoretical basis the authors present of their faith in the index and their asserted decomposition has been falsified.  It is far more likely, therefore, that the decomposition techniques add error to an index that was constructed on the basis of a false theory.  We cannot measure either error because we cannot measure overall risk (conceived of as implied volatility) or either assumed subset of implied volatility ("risk aversion" and "uncertainty").

The ECB authors admit to a telling bit of uncertainty about "uncertainty" in their discussion of purportedly decomposing the VIX index.

"However, the VIX index, used by Bloom (2009) to measure uncertainty, can be decomposed into a component that reflects actual expected stock market volatility (uncertainty) and a residual, the so-called variance premium, that reflects risk aversion and other non-linear pricing effects, perhaps even Knightian uncertainty. Establishing which component drives the strong co-movements between the monetary policy stance and the VIX is therefore particularly important."

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William K Black , J.D., Ph.D. is Associate Professor of Law and Economics at the University of Missouri-Kansas City. Bill Black has testified before the Senate Agricultural Committee on the regulation of financial derivatives and House (more...)
 

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