Tuesday, May 18, 2010

What is the Risk of Global Contagion?

We all know that the VIX, a measure of stock options activity, is known as the Volatility (or fear) Index.  The higher it is the more uncertainty, volatility and fear there is in the U.S. markets.  But is there a measure of global volatility, ie. global fear?  Private investor Bill Luby authors the "Vix And More" blog at http://vixandmore.blogspot.com and seems to have come up with a pretty good proxy to measure just that.  He compares the VSTOXX, the volatility of Europe's STOXX 50 index, to the VIX in a ratio.  The farther the ratio rises above 1.00 (the more divergence there is to the upside between the two volatility indexes) the more the problem is restricted to Europe and the less is the danger of global contagion his theory goes.  Conversely, as the divergence between the two indexes decreases (approaching 1.00) the danger of global contagion increases.  Furthermore, historical data going back to the market peak in late 2007 show that as the ratio went below 1.00 the problem was initially seen to be a U.S. volatility problem.  I love the original thinking behind this simple ratio, and applaud Mr. Luby on his effort, which has gained a good deal of attention this week.  It may be a bit of a stretch for some to equate the action of these two indexes to "global" consequences - but not this observer.