Blog: Is Equity Risk Declining? Or is it just wishful thinking?
The falling VIX may be a sign that “fear” is declining. But risk has multiple dimensions and its other facets don't agree.
The VIX and other implied volatility indicators have fallen back as they did before the SVB crisis. While many take this as a sign that “fear” is declining, things are still in a precarious position where another shock could be taken very badly. In the end, the decline in the VIX may just be another example of wishful thinking.
The Real Utility of the VIX
For many years I’ve used implied volatilities as indicators of market sentiment. Not because they are a good predictors of volatility, but because they are, in essence, a way of indexing continuous maturity options. As such they reflect the demand for downside protection in a long time series. When implied vols are low, hedging is cheap because the market perceives that downside risk is low. When implied vols are high, the reverse occurs. It’s like the demand for flood insurance increasing as the waters are rising and decreasing after the flood.
But do low implied volatility indicators, like the VIX, give an all clear signal for the market? Not necessarily.