India VIX: Association with domestic and global financial markets and the road ahead

Abstract

Volatility measurement and forecasting is a topic of prime interest in the field of finance. The recent global financial meltdown has increased the utility of market volatility measurements, both to the regulators as well as the investors. A full blown volatility index was first introduced by the CBOE in 1993, which was later modified in 2003. India is the only emerging country to have a volatility index calculated on an organized exchange. The India VIX, launched in April 2008, basically follows a similar computational methodology as the CBOE VIX. Although the India VIX index is not made tradable yet, talks are going on between the National Stock Exchange (NSE) and the regulatory bodies likes Securities and Exchange Board of India (SEBI) in order to launch derivatives products based on this index. Owing to its inherent negative correlation, these derivative products will serve the purpose of hedging investor risks against the stock price variations. Similar products are quite popular in the US – however, volatility index based derivative products launched in various other countries have failed severely. In the wake of this present situation, it is necessary to study the India market characteristics and its readiness for such derivative products. We have performed a thorough study of the computation methodologies of the India VIX as well as other volatility indices and identified salient differences between them, which might affect the performance of volatility-based instruments. We have also studied the dependencies and lead-lag relationships between the volatility indices of India and other developed countries. Finally, we have used a framework to assess the economic and process requirements for volatility based derivative products to succeed in a market and assessed India’s readiness based on those. It can be concluded from our analysis that the similarity with the other markets across the world, satisfaction of basic criteria such as negative correlation with underlying stock index and positive correlation with stock trading volume as well as the absence of similar effective hedging instruments make India VIX based derivative products an attractive option for the Indian market. However, before launching any such product, small changes (e.g. real time reporting of India VIX) need to be made such that the products can function properly in the market and gain popular acceptance.