Investments, tenth edition


“Fear” Gauge Showing Little of It



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  “Fear” Gauge Showing Little of It 

 On the floor of the Chicago Board Options Exchange 

(CBOE), those who trade in fear have seen little but calm. 

 Measures of volatility in U.S. markets are pointing to 

relative calm, but some investors say the low readings are 

a sign of complacency. Unlike the rocky ride in the stock 

market since the U.S. presidential election, the CBOE’s 

Volatility Index, or VIX, has registered tranquility. For four 

months, the so-called fear gauge of financial markets has 

traded below its two-decade historical average of 20, its 

longest such streak in more than 5 years. 

 Some investors worry that the low readings are a sign 

of complacency, and that the potential for further declines 

in response to unexpected bad news isn’t reflected in stock 

prices. These investors say various barometers of skittish-

ness could tick higher as the year-end deadline nears for an 

agreement on taxes and spending. That anxiety also would 

likely be reflected in increased volatility in the stock and 

commodities markets. 

 The VIX is an index calculated from the prices investors 

are willing to pay for options tied to the Standard & Poor’s 

500-stock index. As investors become nervous, they are will-

ing to pay more for options, driving up the value of the VIX. 

 As market watchers search for clues about whether the 

relative calm can last, some of them are looking back to 

the early summer of 2011. Back then, the VIX was trading 

at levels close to today’s, even though market pundits wor-

ried that lawmakers wouldn’t agree to raise the debt ceil-

ing. That scenario could have led the U.S. government to 

default on its debt. 

 Within a few weeks, as the debt-ceiling wrangling was 

going down to the wire, Standard & Poor’s cut the U.S.’s 

long-term triple-A credit rating. The VIX nearly tripled to 

48 in a span of two weeks. 

 “The whole situation leads me to believe that this lack of 

a cushion in the market will lead to wilder shocks” to mar-

kets if negative events happen, says Michael Palmer of Group 

One Trading who trades the VIX on the floor of the CBOE.  

 Source: Steven Russolillo and Kaitlyn Kiernan,  The Wall Street Journal,  

November 26, 2012. Reprinted with permission. © 2012 Dow Jones 

& Company, Inc. All Rights Reserved Worldwide. 

 WORDS FROM THE STREET 

bod61671_ch21_722-769.indd   744

bod61671_ch21_722-769.indd   744

8/1/13   8:11 AM

8/1/13   8:11 AM

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  C H A P T E R  

2 1


 Option 

Valuation 

745

which increases the option value, it also entails more dividend payments, lowering the 



expected stock price at expiration and thereby lowering the current option value. 

 For example, suppose that a stock selling at $20 will pay a $1 dividend in 4 months, 

whereas the call option on the stock does not expire for 6 months. The effective annual 

interest rate is 10%, so that the present value of the dividend is $1/(1.10) 

1/3

   5  $0.97.  Black 



suggests that we can compute the option value in one of two ways:

    1.  Apply the Black-Scholes formula assuming early exercise, thus using the actual stock 

price of $20 and a time to expiration of 4 months (the time until the dividend payment).  

   2.  Apply the Black-Scholes formula assuming no early exercise, using the dividend-

adjusted stock price of $20  2  $.97  5  $19.03 and a time to expiration of 6 months.    

 The greater of the two values is the estimate of the option value, recognizing that early 

exercise might be optimal. In other words, the so-called    pseudo-American  call  option 

value    is the maximum of the value derived by assuming that the option will be held until 

expiration and the value derived by assuming that the option will be exercised just before 

an ex-dividend date. Even this technique is not exact, however, for it assumes that the 

option holder makes an irrevocable decision now on when to exercise, when in fact the 

decision is not binding until exercise notice is given.  

15

  



    


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