Monday, August 15, 2011

Volatility is spiking: will stock prices fall?

Colleague Bob Whaley's volatility index is spiking.  It is a measure of risk, and typically as volatility increases, risk-averse investors bid down the price of risky assets, thereby increasing their expected returns.  In equilibrium, investors have to be compensated for bearing risk.  In the graph below, we see that stock prices move counter-cyclically to the volatility index.  The crash of March 2009 corresponded to a peak in the volatility index.

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