The Economist: Volatility, When It Returns, Will Devastate the Markets

Pay special attention to the 2nd from last sentence.

Buttonwood

Sting in the tail

Apr 12th 2007

From The Economist print edition
Is low volatility making the world too complacent about risk?

http://www.economist.com/finance/displaystory.cfm?story_id=9009170

ONE can only marvel at the financial sector's ingenuity in finding new assets to trade. Unfortunately, though, its innovations often only create more things to worry about.

Twenty years ago, volatility—the rate of change of asset prices—was not a separate type of investment. Investors would have happily agreed that sharp falls in prices were a bad thing, and left it at that. Now commentators worry about why the volatility of most financial markets has been so low. Even the recent turbulence, including a stockmarket plunge on February 27th, proved short-lived.

The International Monetary Fund's latest semi-annual Global Financial Stability Report is sanguine about concerns such as the American housing market. But it frets about a potential “volatility shock” in the financial system that could “precipitate sharp portfolio adjustments and a disorderly unwinding of positions,”—or, in other words, a panic.

The fund suggests the low volatility of recent years may be owing to greater economic stability, improved central-bank credibility or the better dispersion of risks around the financial system. But part of the explanation could also be cyclical, notably abundant liquidity, low borrowings by companies and high risk appetites.

These factors can feed on themselves. When volatility is low, investors are tempted to take more risks. They will borrow money in low-yielding currencies to invest at higher yields elsewhere (the carry trade). They will write options, earning premiums for selling insurance against extreme market movements. The danger, as the IMF points out, is that investors can be badly caught out when trends change.

Volatility can be measured in two ways. Realised volatility looks at the actual movements of prices in financial markets. But the more commonly used ratio, the Chicago Board Options Exchange's Vix, looks at “implied” volatility. This is backed out of option prices. The price an investor is willing to pay for an option depends on a number of factors including interest rates and the relationship between the market price and the exercise price. What remains when all these factors have been eliminated is the mystery ingredient—implied volatility.

The ever-inventive financial sector has found ways to trade the difference between realised and implied volatility. Investors can take part in a “variance swap”, whereby one counterparty agrees to receive implied volatility and the other receives realised.

So if you want to take a bet on market turbulence, you would generally opt for the “realised” part of this swap. But unless that turbulence appears quickly, such a bet will lose money. This is because implied volatility is generally higher than realised. In other words, most of the time, it pays to bet on volatility staying low.

Indeed, volatility has a “curve”, rather like the bond market, which generally slopes upwards over time. The Vix represents the short-dated end of that curve. Only rarely, as on February 27th, does the curve “invert” so that short-term implied volatility is higher than long-term.

So it need not necessarily be that investors are complacent in allowing implied volatility to drift so low. The expense of betting on higher volatility may simply be putting them off.

The IMF is unconvinced. It detects a worrying sign of complacency—“tail risk” in the options market. Ever since the crash of October 1987, when Wall Street fell nearly 23% in a day, investors have been sensitive to the risk of an extreme fall. They have been willing to pay a higher price (as measured by implied volatility) for extreme out-of-the-money options than for contracts that insure against smaller market declines. But this premium has been declining sharply in recent years. In other words, investors are becoming less worried about extreme events.

Since 2003, being blasé has been the most profitable strategy. Risky assets have performed well; for example, the spreads on emerging-market debt recently hit an all-time low. Market shocks have been subdued. Even February 27th's 400-point fall in the Dow Jones Industrial Average came low down the historical league table of percentage daily falls.

But what might cause risk appetite to change and volatility to soar? The simple answer is Harold Macmillan's phrase, “Events, dear boy, events”, perhaps some geopolitical incident or unexpected corporate failure. Emerging-market debt would be a big casualty of such a shift. The IMF reckons that, if volatility moved to two standard deviations above its post-1990 average, emerging-market debt spreads would more than double. Something to worry about indeed.

 

I was expecting some pullback here but did not happen. I'm still long some stocks with a stop below last 2 week's low. The positions are small but profitable.

I'm rephrasing makloda from another thread. During 99-00, many people knew that the techs were in a bubble, but anyone who shorted it then lost a lot of money. Right now being long is the only good play.

Another important thing is that crashes do not appear out of the blue. Usually you'll see some good size sell-offs (more than 1% decline in DOW, and S&P on the same day) before the actual crash. It happened in 87, 98 and 01.

This looks like the bull-market for the ages. We do not need to catch every top or bottom to make money. If we can ride the bull and stay in cash during the bear market, we'll come out ahead than 90% of the people. Just last year 1350 seemed so far away and now we're at 1500. I do not know what the fair value is but I know that the trend is up right now.

 

This is in part why i have felt that an EM short was tehe way to go. However the Economist is always years early in its calls so if this is what they are saying now it maybe 2009 or 2010 before what they are talking about comes to pass. They called the housing slump in the Uk two or three years ago and has yet to start.

 

They called the U.S. housing recession absolutely brilliantly, though, in July of 2005, a year before it began.

 

Housing crash was non-event as the market is stablizing and even starting to pick up in certain Micro-economic areas.

Subprimes did not wreak the havic that the idiot pundits claim it would and America's hero (not mine) Buffet stated that very little fall out would spread.

Economic numbers are solid as can be at this moment, Oil is with in normal pramaters for now, GAS is going up due to "Refinery Issues" but not due to Oil prices.

Every "JOE SIXPACK" is now back in the market and "Foreign Capital" can purchase 2x as much of our markets as we can.

Employment is stable.

IRAQ withdraw is on the horizon thanks to the demoRATZ and the Weakness of the Republican Leaders.

There is nothing in sight that I can see that will cause any sudden VIX spike, volititly, Crash or what ever most of the un-educated traders are predicting.

BlackSwan= Massive Terrorist Attack and that is the X factor for now.

The biggest storm on the Horizon is 2008 elections and that is a way off. Besides the country is split 50/50 on the parties and thus I do not see much of a reaction from the markets until we get close to the Campaigns.

It will may mimic the trading days of GORE vs BUSH and for all of you who were trading with us back then, you remember those "buy the Gore Dips" sell the Bush Rallies.

 

I agree in that the housing bubble was overblown by the media and wasn't a big deal.

Historically the US markets have trended higher. If you look at a 20 year graph of the dow you can see a smooth curve with some volatility in the late 80s, early 90s, and early 2000. But aside from those turbulent volatile periods the market has risen gently.

 

So why aren't we raising rates?

 

Only you and your pal stock_turder have treated the "housing crash" as though it's already over...many people, now including Lareah of all people, expect it to get much worse...although, that's the part of us that seem to have dug deeper than CNBC level intelligence into the issue.

 

A black swan is by definition something you haven't seen before and can't predict. A massive terrorist attack is a light grey swan. Everyone is expecting it sooner or later.

You listed a some predictable, pedestrian, run of the mill risks, but you can't list real black swans or they wouldn't be black swans. And they are the things that really take down markets, because they aren't priced in.

What's unique about today's markets is not that there is a higher risk of black swans -- they are unpredictable by definition, so it's impossible to say what the risk is -- but the unprecedented risk appetite and hence brittleness of the global economic system. Smaller truly unexpected shocks can have greater impact when risk has been priced so low. Or at least, that's the case the Economist is making.

Martin

 

Couldn't agree more with this article. I'm leveraged long and keep selling ES puts for zero risk extra income. 100% up room to go $$$