“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.
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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.
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