An Analysis of the Volatility Index With the Vector Error Correction Model

Abstract

The primary objective of this study was to examine the causal relationships between the S&P 500, the Dow Jones Industrial, the NASDAQ Composite, and the VIX indices using the VECM method. The findings demonstrated a strong mutual causal relationship between indices. This relationship strongly indicated that other indices tend to follow the VIX index. The direction of this relationship is most valid for American stock markets. Considering the causal relationships between other country indices and the VIX, it can be said that this relationship will remain weak because the VIX index only represents the American markets. Furthermore, even if the relationships between the VIX index and other country indices are accepted as econometrically correct, the mutual causal relationships found cannot go beyond illusion. A foreign investor should not build a portfolio based solely on the VIX index which reflects future expectations only in the American market. However, a foreign investor can use the VIX index as a great metric in the process of minimizing portfolio risk.