The connections between risk, human psychology, volatility and the VIX

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by Shaun Richards
The last week or so has seen something of a change in financial markets. The falls in Bitcoin have continued but in addition equity markets have hit rough water including quite a storm as they plunged yesterday. The falling over 1000 points club was started by the Dow Jones Industrial Average in the United States and then joined by the Nikkei 225 equity index in Japan. An irony in the situation can be found in the way that one of the possible factors causing this has seen its drop stop and be replaced by a bounce. By this I mean bond prices as for example the yield on the ten-year Treasury Note has fallen from the 2.88% it rose to on Friday – in response to a stronger average hourly earnings reading – to 2.72% now. So happy days for those who have some bonds ( yet again) although I caution against the phrase “flight to quality” as neither yield seems to offer much protection against risk to me. The truth is that it has become something of automatic reflex to mark bonds higher when equities plunge.
However after a period of relative stability we have some action and this brings us into a few spheres involving risk, human psychology and the concept of volatility. As an aside one of the markers may be in play. From Vivienne Nunis of the BBC.

As markets in Europe fall after tumbles in Wall St and Asia, most economists are staying calm, calling it a correction and pointing out fundamentals of the US economy are still strong..

They always say that as after all like Ratings Agencies even if it all goes wrong they are likely to be even more in demand in a clear example of perverse behaviour that questions our rationality as a species. Meanwhile this probably wasn’t a cause but who knows?

Plus, the Berlin Wall has now been down for longer than it was actually up. Professor Axel Klausmeier of the Berlin Wall Foundation tells us how the wall still makes its presence felt, almost 30 years since it crumbled. ( BBC)

Hard to believe isn’t it? For younger readers it was a really really big deal at the time.
This is on its own a simple concept but hard to quantify. Many have claimed to have mastered it but this has often turned to arrogance as we discovered in the mid-1990s when a fund called Long Term Capital Management blew up. I guess we should have been warned by the name! The list of luminaries was long including Myron Scholes who was jointly responsible for an options pricing model used by many including me. There was one lesson in risk which is if you are big enough especially in the derivatives world you get bailed out as the US Federal Reserve stepped in. Also there was a curiosity in the timing as Myron won his Nobel ( strictly Riksbank) prize in 1997 which was just in time for LTCM to collapse in 1998.
Derivatives and risk squared and cubed
If everyone simply bought and sold then financial risk would be relatively limited and mostly related to the currency markets. But derivatives add two types of risk. Firstly you can sell as an opening trade and secondly that you can trade on margin meaning that if you wish you can increase your exposure for the same expense. So if your margin is 10% you could have 10 times as much exposure which is what is meant by gearing. Here is a catch though if you gear up like that then you can be caught out simply by the margin required increasing.
Should such a thing go wrong then it accelerates for the reasons described above. In other words you pay for your greed. An example of this was Nick Leeson of Baring Securities whose enormous bets in Japanese equity derivatives broke not only the company but its owner Barings Bank. Such a large blow-up has another problem which is that other market players figure out what is happening as matters escalate and move prices away from the fund/player in distress.
This is a simple concept of out of the ordinary market moves which is harder like so many things in practice than reality. The mathematics comes around  the concept of a standard deviation. Here is the FT definition.

In a series of variables, a way of measuring the extent to which any one of those variables approaches the average of that series.

Don’t worry if that does not help. It tries to calculate an idea of dispersion. So things that might look like volatility aren’t really as for example the equity market rallies of last year had a mean you could plot reducing the volatility. The current move generates volatility in essence because a reversal is against the mean especially if it is a sharp one.
The next issue is that we can calculate what volatility was but we do not know what it will be. The two concepts are sadly often merged but volatility from option prices should be called implied volatility as market makers and participants – including me – do not know what it will be. If there has been someone who does know then they have had the good sense to keep very quiet about it!
Human psychology
Here is a real problem which is that it seems safest when nothing is happening. Except of course periods of stability do end and if you let yourself fall prey to that line of thought you will be selling risk just as it is about to blow. So human psychology leads to the temptation to sell risk for the least premium. This is another way how things can go wrong in a leveraged world,
The Vix Index
This is a way of attempting to capture much of what I have described above. Here is the FT Lexicon.

The Vix index is an index of expected future price volatility implied by options contract prices.  It is often called a fear index because its value rises when investors are concerned about future volatility.

Actually more recently it has been something of a greed index as developments of it became seen as easy money.

 A few years ago, the CBOE began to list derivatives on the Vix, a market that has grown considerably.

At this point the USS Enterprise is on yellow alert. Before we get to the type of risk that is being squared let me add that the bit below underplays things in my opinion.

 the Vix may not truly mean what it is conventionally assumed to mean (expected volatility), and therefore we would be allowing an undecipherable ghost to move markets

The Vix does not mean what many people think it does and here is another issue it will suck you in as it will seem most right when it is about to go most wrong.
Imagine you have a geared position in the Vix index as you look at the chart below.
As you can see selling derivatives on this would have looked better and better ( tempting you to increase your exposure) and even the language does not help as the word carry implies you are getting a type of interest. Of course we have seen “carry trades” both implode and explode in the currency markets before. The new situation is explained well below.

At this stage we wait to see if this is a correction or something more. But the environment may already have changed even if it is the former. This is because things got ever more highly geared as the lack of volatility made people think that it was ever less likely to return. Some today will be mulling this. From George Pearkes.

 prospectus. Right but not obligation to accelerate on an 80% decline based on intraday index price. The question: did we get there after-hours, and do after-hours values count as part of an index day? Anyhow, good luck folks.

There were exchange traded notes or ETNs on this as we wonder if they do still exist which only adds to the issue of how you hedge something which may or may not still exist?! How much might be involved in the short volatility game well this on FT Alphaville tries to quantify it.

Now, there could be as much as $100bn of outflows from funds that trade using those types of strategies, says Kolanovic. He thinks the outflows could affect CTAs, along with funds that bet on low volatility, target volatility levels, or follow risk parity strategies.

Along the way such funds if they tried to hedge their position would have added to the drop that was hurting them. Should they do so and the market rallies then they would be hit both ways. Their response to the Vix going over 45 as it has as I have been typing this would be if we exclude the likely profanity to sing along with Kate Bush.

Wow! Wow! Wow! Wow! Wow! Wow!
Wow! Wow! Wow! Wow! Wow! Wow!

Meanwhile if we return to monetary policy imagine you were the incoming Chair of the US Federal Reserve and you stand to wonder if your first move might be to introduce QE4?


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