can occur in the absence of information and is based on unfounded assumptions. [5] Therefore, what traders and investors need is a general indicator of global riskiness. If global riskiness is low, the probability of a shock in a small context becoming a major crisis is also low. If the market feels riskiness is high, the slightest rumble can set off shock waves, and perhaps in some asset classes linked to the source by many degrees of separation.
Unfortunately, we do not yet have a single index of global riskiness that works in all instances. But we do have a selection of indicators and indices that send out warning sounds ahead of shocks that cause global stock markets to plummet and safe-haven buying of developed market bonds.
Let’s look at these now.
Risk gauges
There are a selection of indictors that can be used to assess risk in financial markets. Many of these are based on markets or areas other than FX, but conclusions can be extrapolated from these to the FX market. These risk gauges give FX traders reliable guidance towards direction, but not necessarily about the magnitude of moves. Traders use these risk gauges mostly to red flag potential trend changes.
These indicators are:
1 The VIX
2 Risk reversals
3 Federal Reserve stress indexes
4 Bank stress indexes
5 Inflation breakevens and inflation swaps
6 Corporate spreads/credit default swaps
7 Prices of commodities
1. The VIX
One of the most closely tracked risk instruments is the Chicago Board Option Exchange’s (CBOE’s) volatility index or VIX (also called the fear factor). The CBOE describes the VIX as “an up-to-the-minute market estimate of expected volatility that is calculated by using real-time S&P 500 Index (SPX) option bid/ask quotes.” It is seen as a proven risk gauge.
To calculate the VIX, the CBOE uses “near-term and next-term out-of-the money SPX options with at least eight days left to expiration, and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.” While the VIX is quoted as a percentage, most analysts drop the percentage sign and just use the number itself. When the VIX price goes up, it means risk aversion is kicking in and the S&P 500 typically falls. Conversely, when the VIX falls, there is more risk appetite in the market and the S&P usually will rise. A graph of the S&P 500 juxtaposed over the graph of the VIX would provide roughly a mirror image of the risk indicator. See Figure 2.2.
Figure 2.2 – VIX and S&P 500 (inverted scale, monthly)
As well as VIX, the CBOE calculates other volatility indexes including the NASDAQ-100 Volatility index (VXN) and the DJIA Volatility Index (VXD). In 2008, the CBOE introduced other indexes incorporating VIX methodology. These new contracts include the Crude Oil Volatility Index (OVX), the Gold Volatility Index (GVZ) and the EuroCurrency Volatility Index (EVZ), all of which use exchange-traded options based on the United States Oil Fund LP(USO), SPDR Gold Shares (GLD) and CurrencyShares Euro Trust (FXE), respectively. While traders may occasionally use these other tools, the focus remains on the VIX and the latest signal that the fear factor is emitting.
A VIX level below 20 is deemed positive for risk and a VIX level over 40 is deemed negative for risk, with the range in the middle deemed indecisive. A timeline of the VIX shows that after starting the millennium around 24.15, the index soared to a high of 43.74 in the wake of the 9/11 attacks and then slipped back into the 20s and 30s in 2002/2003. The VIX stood at 29.15 at the start of the Iraq War in March 2003, before closing the year at 18.31. At the time of Hurricane Katrina in August 2005, the VIX was trading below 15.
The index remained offered in subsequent years, with the low volatility indicative of the extreme risk appetite present in the market. The VIX bottomed at a 13-year low of 9.39 in December 2006, very close to the life-time low of 9.31 seen in 1993. By October 2008, at the peak of the US financial crisis, the index had reached a life-time high of 89.53. During key stress points of the euro zone peripheral crisis, the VIX topped out a bit below 50 on two occasions, first at 48.20 in May 2010 and again at 48.00 in early August 2011. The velocity of the VIX rise or fall can be a factor affecting risk also. On 8 August 2011, when the VIX topped out at 48.00, the index rose 50% in a single day.
The VIX and the S&P 500 do not always move in lockstep with each other; there is often a sizeable time lag. In October 2008, the VIX topped out close to 89.00 and subsequently edged lower into the end of 2008 and early 2009, suggesting diminishing risk aversion. In contrast, the S&P 500 continued to decline into late 2008 and early 2009, bottoming at 666.92 only in March 2009 (VIX closed at 49.33 that day). A trader trying to buy US stocks cheaply in late 2008/early 2009, thinking they had bottomed, would have experienced buyer’s remorse by getting in too early. The lesson to be learned is that while the VIX can be considered a good predictor of future direction of the S&P 500, a turn in market sentiment suggested by a drop or rise in VIX volatility may not translate to an immediate shift in stock positioning.
Currency traders use swings in the VIX as a gauge of risk appetite for US and global stocks and, depending upon the FX link at the time, buy and sell currencies accordingly. Starting in September 2010, the CBOE began to offer weekly options (both puts and calls) on VIX futures, which allowed investors to bet on VIX direction for the first time. In the past, if an FX trader saw the VIX falling sharply, he would conclude that US stocks might also fall and drag the dollar with it. More recently, since the US and euro zone financial crises, a falling VIX would suggest risk friendly positions were being pared and red flag the potential for safe-haven demand. Under this scenario, the dollar might firm on safe-haven demand.
It’s not only FX traders that use VIX as a risk gauge. Figure 2.3 shows VIX against the oil futures contract. Oil led the VIX up from 2004 to 2008 and as oil crashed at end-2008 so did the VIX. In fact, VIX stayed low as oil resumed its rise, except for spikes in both 2010 and 2011. The correlation is not very strong and it lags, but fear of equity market volatility arises from economic conditions and in turn has economic implications that affect perceived demand for oil. It can be bit head-spinning, but it’s not without a certain logic. Since FX traders watch oil prices as well as VIX, when they are both signalling rising risk we can expect magnification of a pro-dollar bias.
Figure 2.3 – VIX and Crude Oil Futures (monthly)
2. Risk reversals
Another measure of bias or directional preference used by currency traders involves risk reversals. Market players, especially those trading FX options, watch the skew in option risk reversals to see which way sentiment is leaning in a given pair. A risk reversal is the difference between the implied volatility of an OTM (out of the money) call (right to buy a currency) and that of a put (right to sell a currency) option of similar maturities. Typically, 25-Delta calls and 25-Delta puts are tracked by the market players.
If a risk reversal is positive (calls are more expensive than puts) it means that for a given maturity (one-month, two-months, three-months, etc.) buying option protection or insurance in the event of a currency move higher is more expensive than buying protection
