Markets at record levels, but pre-poll jitters take VIX to 30-month high

Written by fe Bureau | Mumbai | Updated: Apr 22 2014, 06:01am hrs
MarketSince March 22, 2013, the India VIX has risen from 15.88 to 34.39, its highest since October 5, 2011
Indian equities scaled new highs on Monday with the Sensex hitting 22,764.83 at close and the 50-share Nifty ending the session at 6,817.65. Investors continued to stay bullish on the markets in the hope a BJP-led government will take charge at the Centre after the Lok Sabha elections foreign funds have pumped in close to $5 billion so far this year.

Surprisingly, the India VIX the gauge of the underlying volatility in equity markets climbed to a 30-month high on Monday; volatility has nearly doubled in the last one month. Historically, the India VIX has maintained a negative correlation of 81% with the 50-share Nifty, but traders have now turned cautious as the outcome of the election draws nearer. Apart from Indonesia, India is now the most expensive market in the region and trades at around 15 times one-year forward earnings, in line with the historical average. Market watchers believe there could be more steam in the rally; the lifting of the ban on iron ore mining in Goa, by the Supreme Court on Monday, boosted the sentiment.

Since March 22, 2013, the India VIX has risen from 15.88 to 34.39, its highest since October 5, 2011. Nifty options expiring in May are assuming a higher weightage in the VIX than April contracts that expire this Thursday.

As a result, the VIX value has jumped past 30 ahead of the critical date of May 16 when election results will be announced.

India VIX is the volatility index based on option prices of Nifty index and represents the expected market volatility over the next 30 calender days. It is derived by using a methodology provided by the Chicago Board Options Exchange. The National Stock Exchange (NSE) introduced the index in late 2007 through its licensing agreement with S&P.

In February, Bank of America Merrill Lynch said that volatility in Indian markets was likely to rise sharply as general elections near because capital markets are usually jittery prior to the declaration of election results due to uncertainty of the outcome.

Citing example of the previous general elections in 2009, BofAML said that the India VIX had jumped sharply prior to the declaration of results showing the underlying fear of investors on the uncertainty of the results. We would expect VIX to rise as we near May (general election 2014) this year too, it added. In 2009, India VIX had rallied from 36 on April 1 to 54.76 a few days before the election results. The index peaked at 56 after the poll results confirmed the Congress-led UPA as the winner, but fell sharply to 41.97 three days after the results were announced.

Traders point out that the computing formula of the VIX, which considers the variance between the near month and the mid-month Nifty options, is adding to a sharp rise in the index value.

Although hopes for a favourable election outcome have caused the equity benchmarks to gain more than 8% this year on the back of strong FII inflows of about $4.8 billion, in the recent past experts have flagged caution of the likelihood of opinion polls going wrong.

Recently, UBS pointed out that opinion polls went wrong in both 2004 and 2009 due to overestimating vote share of BJP and underestimating vote share of third front. g ...opinion polls were not accurate predictors of Indias previous two elections, and there is a risk that the NDA will have to seek more regional parties to form a government. This could dilute the NDAs economic agenda., Standard Chartered said in a recent report.

While until two months back the computed value of VIX index represented the implied volatility reflected by the Nifty options, traders can now also trade on the VIX futures recently introduced by NSE.

Three weekly serial future contracts on VIX expiring every Tuesday are now available for trade since February 26, 2014. These futures which debuted with a turnover of Rs 325 crore, witnessed a turnover of Rs 100 crore on Tuesday.

Even as the Sensex has converged with its long-term historical valuations after rallying 13% since mid-February, analysts are of the view that market multiples could expand further if a strong government comes into power. According to Macquarie market can rally 7-20% from the current levels based on the strength of the new coalition government.