Implied Volatility and Stock Market Speculation

Abstract

The stability of an economy is directly linked to the stability of the capital markets in which it operates and vice versa. The capital market stability is in turn linked to the asset price dynamics; most of these asset prices are modelled based on expected rate of return. The expected rate of return and direction of markets is determined from the implied market volatility (VIX index). The implied volatility is a forward looking variable which tells about the realised market volatility based of market participant’s expectations. Most of the times this implied volatility is over estimated compared to the realised volatility due to the speculative behaviour of the market participants. This speculative behaviour causes virtual dynamics in the implied variables which in turn caused virtual dynamics in the individual asset prices. The virtual dynamics in the asset prices causes the divergence in the realised or fundamental value of the market; which can be attributed to the irrational behavioural of the financial market participants. The present paper aims at understanding the source and level of the speculation, and also an attempt has been made to develop a novel quantitative behavioral framework to understand and rectify this speculative behaviour. An empirical analysis has been carried out on the S&P 500 Index and CBOE VIX Index to validate the proposed model. Some interesting results have been obtained from the present study which clearly shows the quantitative behavioural model has the capability to convergence the expected volatility with the realised market volatility, this helps the market participants, regulators and policy makers to make necessary corrections based on the predicted speculation.