How Good is the VIX as a Predictor of Market Risk?

Abstract

Volatility is a metric widely used to estimate financial risk. The VIX is an index derived from S&P 500 options prices designed to estimate the market’s expected 30-day volatility. Robert Whaley, the creator of the VIX, argued that it provided a cost-effective way to hedge risk but we question Whaley’s underlying assumption in this paper. We examine the VIX and implied volatility as a proxy for risk. Our studies show that the VIX consistently over-estimates actual volatility in normal times but it underestimates volatility in times of market crashes and crises making it unsuitable for many risk-management applications.