Riding the cycle

Why volatility will never go away

CAN it only be a year ago that volatility was so low in the financial markets? Traders must have found their lives awfully dull, without so much as a currency crisis to get the pulse racing.

Some began to argue that volatility had moved to a structurally lower level thanks to the activity of hedge funds and to the development of complex products and derivatives. A new, more sophisticated financial system had spread risk more efficiently, it was said.

But over the past 12 months, the standard measure of stockmarket volatility, the Vix (or volatility index), has roughly doubled. On top of that, there have been wild swings in government bond yields, a jump in debt spreads and the continuing decline of the dollar.

To grasp one reason why volatility has surged, you need to understand how the Vix is calculated. The measure is derived from the world of options, the instruments that allow investors to protect themselves against (or speculate on) future price movements. A call option, for example, gives the holder the right to buy an asset at a specified price within a specified period.

Say there are two shares, each trading at $80; one is a young technology company, the other a staid power generator. In each case, there is an option contract offering the chance to buy the shares at $100 at some point within the next three months. Logically, you would expect to have to shell out more for the option to buy the technology company's shares, since it is more likely suddenly to announce some whizzy breakthrough that causes its share price to shoot upwards. In other words, it costs more to purchase options on assets that are likely to be more volatile in price.

When one “reverse engineers” an option price (taking out factors such as the time value of money), the residual factor is known as implied volatility, which could be described as the uncertainty applying to the asset. The Vix represents this figure for the S&P 500 index.

The vast majority of options expire without being exercised; the asset price never moves sufficiently to make it worthwhile. To put this in technical terms, the implied volatility in the option price turns out to be higher than the realised volatility. So there are plenty of people who earn a decent income by selling options; just like insurers, they earn a premium every time they make a sale.

In quiet markets, the number of people who want to sell options increases, driving their prices, and thus the level of implied volatility, down. That was one reason why volatility was so low last year. But when the markets went into a tailspin in August, volatility suddenly surged; it became much more likely that those who had previously bought options would be able to exercise them (particularly put options, which grant the right to sell at a given price). Option-sellers suddenly faced losses; some, realising the risks, probably withdrew from the business. That forced implied volatility even higher.

There is thus a cyclical element to volatility, as investors move from complacency to alarm. That fits in with the work of Hyman Minsky, an economist who suggested that periods of stability may sow the seeds of future volatility. If economic growth and interest rates are stable, businesses and consumers will be encouraged to take more risks, and in particular to take on more debt. Eventually, small changes in interest rates will have a much greater impact on balance sheets and on consumer willingness to spend.

A long-term graph of the Vix hints at cyclicality, with periods of great choppiness in the early and late 1990s book-ending an era of relative calm in the middle of the decade. It is hard to say that any level is “normal”; volatility is in itself volatile.

It may be ever so. Another important factor behind market movements must be the difference in incentives between investing institutions, such as pension funds, and the intermediaries that work on their behalf. Pension funds would like nothing better than for asset markets to rise in a steady, predictable fashion, so it would be easy to work out how to meet their liabilities. But that would not be so great for traders. Steady markets would give investors fewer reasons to deal, and so traders would have less chance to earn the spread between sell and buy prices. And the more volatile markets are, the better the chance that a trader will be on the right side of some big price move, and win himself a fat bonus. So traders are tempted into making big bets, and in doing so also add to volatility.

It is small comfort for the rest of us, but every time the Vix jumps sharply, someone at a hedge fund has just earned himself a nice new yacht.