Sting in the tail

Apr 12th 2007
From The Economist print edition

Is low volatility making the world too complacent about risk?

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.