Black Swan or Cygnus Atratus

A Black Swan or Cygnus Atratus is a large water bird. It belongs to the species of the swan family which are commonly found in the wetlands of southeast and southwest regions of Australia. Unlike the more common white Swan, Black Swans are mostly black feathered birds, with white flight feathers and bright red bills.

What is the Black Swan Theory?

In the financial world, a black swan is an unpredictable event that is beyond what is normally expected with potentially severe consequences. Black swan event is an extremely rare occurrence. It is difficult to predict beforehand but becomes obvious in hindsight. Black swan events in the past have caused catastrophic damages to the economy and to financial markets. Some of the recent Black Swan events were Long-Term Capital Management (LTCM) collapse caused by the Russian government’s debt default during the Emerging Market Debt crisis of 1998, the dot-com bubble of 2001, 9/11 terrorist attack, and the global financial crisis of 2007-2009. Because they cannot be predicted many investors simply ignore this.

Black Swan Index – CBOE Skew Index

The CBOE Skew Index or referred to as “SKEW” is an option-based indicator that measures the perceived tail risk of the distribution of S&P 500 log returns over a period of 30-days. Tail risk is the statistical term used to describe the risk associated with an increase in the probability of outlier returns, typically two or more standard deviations below its mean. SKEW is based on the price of the S&P 500 skewness. It is calculated from the prices of S&P 500 options using the same algorithm that is used to compute the CBOE Volatility Index (VIX). The price of the S&P 500 skewness is often a small negative number. So, it is often converted to a value that is more readable typically greater than 100. That is, -2.5 translates to a SKEW value of 125. The value of the SKEW increases with the tail risk of the S&P 500 returns.

SKEW Interpretation

SKEW values generally range from the low-100s to 150s. The higher the SKEW, the higher the perceived tail risk, and hence the higher the probability of a black swan event. A SKEW of 100 means the perceived distribution of S&P 500 returns is normal and, therefore, the probability of an outlier return/event is low.

In recent years, the media and the press SKEW index have increased the public's awareness of global tail risks. As the slope of the implied volatility moves higher, it raises the value of the SKEW Index, which in turn increases the chance of a Black Swan event will occur soon.

In practice the SKEW index has had mixed results in alerting investors to an increased in stock market volatility and hence an impending Tail Risk or Black Swan event.

Prior to the 2015, SKEW recorded high readings along the mid-120s to mid-140s and Tail Risk/Black Swan events were farer apart and less frequent. This trend soon changed after 2015 as SKEW Index has been trading to extreme highs in the low-150s to high-150s. The frequency of these extreme readings has also increased dramatically.

So, is the SKEW Index suggesting a stock market environment that will be more volatile than in the past? And if so, will SKEW be reliable in predicting Black Swan events in the future?