What does one of the most popular and well-known metrics, VIX, tell us about future returns? Academic research (Bansal and Stivers, July 2023) shows that a common, intuitive 20/80 thumb rule can be applied as time-variation in the returns earned from equity-market exposure can be explained well by a simple 2-term risk-return specification, which predicts (1) much higher returns 20% of the time following after VIX exceeds a high threshold at around its 80th percentile and (2) lower excess returns following a high market sentiment. They argue that VIX and market sentiment tend to measure complementary aspects of risk: the level of risk (VIX) and the price of risk or risk appetite (sentiment), and that, thus, both terms should be accounted for when evaluating time variation in the equity market’s risk premium.
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