A common narrative to global markets is that volatility has massively increased. Market participants like to claim a new regime of increased volatility with each and every new negative macro event. From the fright over Ebola all the way to the stock market selloff this year, market participants have theorized about “heightened volatility.” Now that markets are fully in the throes of Brexit and its attendant risks, the question is whether volatility has truly increased?
As a starting point it is quite easy to examine equity volatility through the CBOE Volatility Index or the “VIX.” The VIX is the market’s pricing of implied volatility on the S&P 500 over the next 30 days. That is, the VIX is constructed by using options prices to show the expected amount of fluctuation in the price of the S&P 500 in the near term. It is frequently referred to as the “fear index” which is a misnomer when considering that the index purports to capture prices instead of sentiment.
Since the inception of the VIX, its average level has been very close to 20. The chart directly below shows the VIX since inception.
However, over the past year the average level of the VIX has been 18.31. The chart below shows the VIX over the past year.
There are several observations that can be made based upon the current and historical prices of the VIX. Firstly, an average level is largely irrelevant because the average is effected by steep jumps in prices. For example, on August 17th, 2015, the VIX was 13 and then on August 24th it was over 40. Thus, the frequency of multi-standard deviation moves in compressed times makes an “average VIX level” of less relevancy.
Secondly, an increase in the VIX does not imply a further increase in implied volatility. Out of the six spikes in volatility in the past year, there were only two instances when a closing VIX level of 20 was followed by a higher reading the following trading session. In fact, many stock market professional use an increase or spike in the VIX as a contrarian sign.
Thirdly, the VIX tends stays lower for longer rather than change regimes. That is, the tendency of implied volatility is that it is generally well-behaved. It stays in a lower range for long period of time and then spikes up around unexpected macro events. This is obvious, but it bears remembering when thinking about return distributions.
Global market participants were absolutely shocked by the Brexit vote, but implied volatility did not spike as high as in other macro events. The VIX did spike above 26. However, when comparing the potential negative outcomes of Brexit to a VIX only at 26, it seems that a regime of heightened volatility cannot yet be confirmed.
Assuming that a Lehman Brothers bankruptcy or similar type of event that questions the essence of capital markets is the worst possible risk, Brexit is comparably tame. During the Lehman crisis and the associated market confusion of 2008, the VIX traded above 80 on two separate occasions. With a VIX reading at 26 immediately following the Brexit vote, it can be posited that a Brexit does not pose the same amount of risk as the bankruptcy of Lehman Brothers or the risk associated with a Brexit has not yet been understood by markets and incorporated into asset prices.
Even in the Eurozone, stock market volatility has been relatively tame compared to the potential negatives that Brexit may imply. The chart below is the EURO STOXX 50 Volatility Index which, like the VIX, measures implied volatility in European stocks over a 30 day horizon.
The “Euro VIX” is currently just a touch above its long term average reading, although it has generally been more elevated since the beginning of 2014.
Another asset class that has concerned market participants over the past two years is crude oil. In pricing terms crude oil has lost more than half of its value over the past two years (i.e., from above $100/barrel to below $50/barrel). Although starting from a much higher level, the volatility of the crude oil market has been decreasing since February of this year.
The bond market is also not in a new, near term, higher volatility regime. As measured by the CBOE/CBOT 10 yr. U.S. Treasury Note Volatility Index or the Merrill Lynch Option Volatility Estimate MOVE Index, bonds are not demonstrating materially higher volatilities. The average of the MOVE Index over the past year is a bit over 75 while it is currently priced below 72. Likewise, emerging markets volatility as measured by the CBOE EM ETF Volatility Index is right at its longer term historical average.
The cautionary tale of volatility readings is that market participants can cherry pick data points (e.g., averages) and create spurious assumptions of higher or lower volatility. Implied volatility indices are more akin to a company’s balance sheet than commonly assumed – they are mostly a condition of a certain time and extrapolations of future regimes or changes become quickly exhausted by the contemporaneous pricing of the associated or underlying market.
Perhaps the more interesting question is whether the volatility of volatility itself (“kurtosis”) will change due to Brexit or some other near term macro issue. Probably not, as it is hard make a case based on arithmetic that volatility and kurtosis will somehow divorce. The chart below shows the correlation between the VIX and kurtosis with the VIX in green and kurtosis in white.
Although it seems as though the velocity and importance of macro events has increased recently, it is hard to make wholesale arguments that various asset classes are in new, higher, volatility regimes. That is simply a false narrative and the most likely distribution of returns in volatility indices continues to be below average ranges. We are net yet in a world of permanently higher asset class volatility.
Disclaimer: this is not investment advice. This is for entertainment and education purposes only. This writing is not affiliated in any way with the current employer of Jeremy L. Hill.
Attribution: all charts and graphs are from Bloomberg , L.P.
This article was written by Jeremy Hill from Forbes and was legally licensed through the NewsCred publisher network.
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