Implied Volatility Style Analysis: Risk Aversion versus Uncertainty

This article examines the two most established and widely followed implied volatility indexes, VIX and VDAX, through returns-based style analysis, a tool highly regarded and utilized within the investment community. A volatility index reflects both the stock market’s future uncertainty about the underlying index and investors’ risk aversion in these two markets. We separate the volatility index into two distinct components: conditional variance and variance premium, representing uncertainty and risk aversion, respectively. Our empirical findings show that both volatility indexes are driven largely on average by risk aversion (around 70%), but this result is magnified by crisis observations, which have an outsized impact despite constituting a smaller portion of the dataset. In normal times, volatility indexes are still significantly affected by risk aversion, but the influence is more balanced (approximately 60% risk aversion, 40% uncertainty). Our empirical findings could carry significant implications, given that shifts in risk appetite are widely recognized as pivotal determinants of asset prices and returns, and gaining a clearer understanding of the factors driving the VIX contributes to achieving this objective.