Robert Whaley spent the last four months of 1992 in a small town near Dijon, France, with a set of large hard drives containing what was then the entire series of index option prices from the Chicago Board Options Exchange. On sabbatical from Duke University, he’d been commissioned by the exchange to create a volatility index. With two powerful PCs, he worked out the formula for the Chicago Board Options Exchange Volatility Index. The VIX was unveiled in Chicago on Jan. 19, 1993.
Now the Valere Blair Potter Professor of Management at Vanderbilt University in Nashville, Whaley connected for an interview via videoconference on April 21, the day after crude oil futures had traded at negative prices for the first time.
Jon Asmundsson: In the early ’90s, you were teaching finance at Duke and the CBOE hired you as a consultant in some litigation. Then the exchange asked you to create a volatility index. Can you tell me the story of how that came about?
Robert Whaley: Sure. The CBOE introduced index options early on—I think it was 1983. At that time they were S&P 100 options. And during the October ’87 crash, what had happened was the implied volatility of some put options got to extraordinarily high levels—172%, I think, was the highest one I saw. And there was a class-action suit against the CBOE for sponsoring a market that essentially had these inordinately high levels of volatility. It was eventually settled. The bottom line was I had done some litigation support work for them. In those discussions, the focus was completely on volatility, and the conversation really went toward, “Well, it would really be interesting to have an index on volatility.” So that was the seed for moving ahead with a volatility index.
The trouble you have by focusing in on the implied volatility of a single option is that its maturity changes every day. And its relationship with the underlying index level changes every day as it moves around the exercise price of the option. So the key ingredients to developing a sensible index would be to somehow hold the moneyness constant—make it an at-the-money option by interpolating around the [equity] index level. And by using options with different maturities, interpolate to get a constant 30 days to maturity. So that’s essentially it. What you do is you devise a formula that takes all of the different implied volatilities for these options, and it creates a single definition that is a 30-day volatility of an at-the-money option. So that’s the origin of the VIX.
JA: Was the idea that the VIX would track the buying of puts by institutions to hedge portfolios?
RW: No. As it turned out, that’s the way it is used. In theory, what the index should be doing is giving you an expectation of the future realized volatility over the next 30 days. So it’s not telling me the expected range of stock prices tomorrow. It’s telling you the expected range of stock prices over the next 30 days. It’s sort of an average of the ranges over the next 30 days. People get a little bit confused about it in the sense that they want to tie VIX to how volatile the market is today. That’s comparing apples and oranges. VIX is telling you about the average volatility over the next 30 days as opposed to what the volatility is today. From a theory standpoint, that’s what it should be. But that’s not what it turns out to be.
Look at the level of VIX. Suppose I were to design an experiment—and I have done this multiple times—where I take the level of VIX today and then I simply go forward using a history of the daily level of VIX on day t. I go forward 30 days, and I just compute what the volatility was over the 30 days. And I compare VIX to the future realized volatility that it’s predicting. You can think of an Excel spreadsheet where I have VIX in one column and the other column is what the realized volatility was. If I take the average of those two columns, the average of VIX will be about 400 basis points higher than the realized volatility. And that’s because people pay a lot of money for portfolio insurance. That is, they buy S&P puts. They pay more than their actuarial value, if you like.
JA: That’s true generally for options, isn’t it? That implied volatility is higher than realized?
RW: No. If you look at stock options and do the same experiment—and I have done this in some of my research—implied volatility of stock options is an unbiased predictor of the realized future volatility. This is unique to index options. The index option market is institutionally driven. Stock options are largely retail customers.