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The VIX is calculated using the prices of S&P 500 index options. Here’s a simplified breakdown of the process:
1. Options Selection: The VIX uses options with expiration dates between 23 and 37 days in the future.
2. Price Inputs: It considers both call and put options, focusing on out-of-the-money options.
3. Variance Calculation: The variance for each option is calculated. This involves determining the difference between the strike prices and the forward index level, adjusted by the risk-free interest rate.
4. Interpolation: The variances of the two sets of options are interpolated to get a single value.
5. Final Calculation: The square root of this interpolated variance is taken and then multiplied by 100 to get the VIX value12.
This method provides a 30-day forward projection of market volatility, making the VIX a crucial tool for investors to gauge market sentiment and potential risk.
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