Toronto-based TMX Group Inc. — the operator of the Toronto Stock Exchange and the Montreal Exchange — and New York-based Standard & Poor’s Financial Services LLC jointly have launched a new made-in-Canada version of the volatility index that will give financial advisors a powerful new way to gauge market sentiment.

For Canadians, the new S&P/TSX 60 VIX promises to be a true measure of market volatility because it was designed specifically for this market, says Leon Bitton, vice president of research and development for the MX.

In addition, the MX may also launch a new futures and options market based on the Canadian VIX, he says, noting that this will allow advisors to manage risks for their clients by hedging swings in the market.

This new market could result in a wide variety of other products being introduced, such as exchange-traded funds, Bitton says, adding that the new market could open as early as the second or third quarter of next year.

Several market-watchers praise the introduction of the Canadian version of the VIX because it is expected to provide a useful and accurate quantitative measure of market sentiment.

However, they warn, the MX will have to raise the liquidity of the Canadian options and futures markets for hedging to be effective.

The Canadian VIX is derived from the Chicago Board Options Exchange’s popular VIX, which has been in use since 1993. Often referred to as the “fear index,” the U.S. version of VIX has been an accurate measurement of investor anxiety and a good leading indicator of the S&P 500.

Until now, Canadian market-watchers have been obliged to follow the U.S. version of the VIX because it was the best available measure of volatility.

This has been a good strategy for many years because the Canadian and U.S. equities markets correlated well; however, that is ceasing to be the case, as the fortunes of the two markets diverged somewhat during the financial crisis, primarily because of the strength of the Canadian banks. Thus, the correlation factor now stands at about 60%, a level that Bitton describes as “imperfect.”

Given the discrepancy between the two markets, TMX officials decided it was time to look for something a little more relevant to Canadians’ needs. They spoke with S&P’s indices division and came up with a made-in-Canada solution that is geared toward the peculiar characteristics of the Canadian market, with its relatively strong banking sector and heavy reliance on mining and commodities.

The new Canadian VIX will be licensed from S&P and will use S&P methodology, but it will be based on the cost of S&P/TSX 60 index options on the MX, Bitton says, rather than on S&P 500 stock options, as is the case in the U.S.

S&P will calculate the new index in real time throughout the trading day and post it continuously on the MX’s website: www.m-x.ca/indicesmx_vixc_en.php.@page_break@Much like the U.S. VIX, the Canadian VIX will tend to move in a direction opposite to that of the market. A low VIX indicates a stable equities market and a calm investment community, while a high VIX shows that investors are anxious.

This VIX/market relationship happens because nervous inves-tors tend to buy equities or futures options to protect themselves, thereby driving up both the price of options and the value of the index. In calm markets, inves-tors don’t bother so much with options and their prices, so the VIX falls.

Says Sid Oberoi, senior director, S&P indices, in New York: “The new volatility index will not only serve as a key metric of market sentiment, but will also foster the development of a volatility trading and hedging market in Canada.”

Some Canadian advisors are generally keen on the new volatility index — although they have some reservations.

For instance, Adrian Mastracci, president of KCM Wealth Man-agement Inc. in Vancouver, says the Canadian VIX will be a useful addition to advisor’s toolbox — but just one of many that are available: “It will be another item to look at, but not the only thing you will consider.”

In addition, Mastracci notes, the prime users will “probably be portfolio managers and the more astute do-it-yourself [inves-tors]” — along with institutional groups, fund managers and pension fund managers.

Richard Croft, president of Thornhill, Ont.-based boutique portfolio-management firm R.N. Croft Financial Group Inc. and a longtime columnist with Investment Executive (see page 41), looks forward to the launch of the futures and options market that the MX is proposing.

He sees investing in volatility as an excellent hedging tool because there are few hedges available with a negative correlation to equities markets. Also, he says, as the VIX tends to move more rapidly than the underlying equities, you need only a small hedge to protect clients’ investments.

The key factor for Croft is liquidity — or the lack of it — in a market as small as Canada’s. He points out that few Canadians follow the futures markets in this country, and that may limit liquidity and the usefulness of the Canadian version of VIX.

“It’s a wonderful idea,” Croft says. “But if it can’t trade, it’s not very useful.”

Much like Croft, Aaron Fennell, senior market strategist with the Lind-Waldock division of MF Global Canada Co. in Toronto, likes the VIX because it is one of the few accurate measures of expected volatility based on hard numbers.

“It’s not a gut feeling,” Fennell says, referring to the seat-of-the-pants sentiment that so often drives the markets. “It is a quantitative measure, and there are very few of them. That’s pretty important for us.”

But, like Croft, Fennell says liquidity could be a concern if the MX goes ahead and launches a market based on the VIX because Canada is just not big enough to provide the liquidity needed. IE