Volatility and the Skunk

By Eben Maré, Head: Fixed Income at Absa Asset Management and Associate Professor, University of Pretoria

“What kills a skunk is the publicity it gives itself” – Abraham Lincoln

Investors typically equate volatility (or more technically the standard deviation of asset returns) with risk. In this regard, the CBOE Volatility Index, better known as the VIX, has become a well-known gauge of an investor’s risk appetite or fear. 

The VIX is calculated on the basis of a range of options priced on the S&P500 equity index. The index offers an indication of the 30-day volatility implied by the options market (referred to as implied volatility). 

There are a great many uses for the VIX. Investors base asset allocation decisions on the VIX and try to determine universal relationships between currencies, fixed income assets, and equity markets based on movements in the VIX. 

Figure 1 shows the evolution of the VIX over time – notable is the current levels at multi-year lows. Many investors interpret this fact as a danger signal. Is that correct? Let’s investigate.

From Figure 1 we note that VIX ranges between about 10% and 80%, over the period starting 2004 to date. A conventional interpretation would be that VIX should revert to its mean level … 

Figure 2 demonstrates that VIX can be broken into different regimes – in this analysis we demonstrate two regimes entailing low volatility and high volatility periods. In this interpretation, we enter a period of low volatility or high volatility and exit those regimes probabilistically. The fact that VIX is at multi-year lows therefore carries little forecasting relevance. In essence, volatility is low for possible structural reasons (which we will examine below), we should examine risk on the basis of reasons that could create higher market volatility. (For completeness, the regimes are identified using a Markovian regime switching model.)

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Remember, VIX is the market’s estimate of future implied volatility – only a measure of the realised volatility of the underlying index. The index in turn is the combination of a weighted collection of stocks moving around with a certain amount of independence. It is therefore instructive to look at the market’s estimate of so-called implied correlation of the index. In Figure 3 we highlight the downward trend of the average correlation of price returns for S&P500 index components implied through prices of index based options and single stock options on the largest 50 index components in the S&P500. Lower correlation implies more effective diversification, hence lower volatility. This trend is indicative of the market’s increased confidence in the economy and stability thereof, remember, we have been in a risk-on/off environment since the 2008 credit crisis, a period which had initially been followed by high correlation levels between all asset classes.

Let’s take the analysis one step further. The VIX index has become a risk-based signal, in essence, a traded instrument in its own right. Investors can buy futures and options on the VIX to express their concerns, fears, or satisfaction with the markets. Option and futures markets on VIX have exhibited exponential growth since the 2008 crisis – investors would typically sell options on VIX to ‘harvest’ the so-called volatility risk premium. It is therefore instructive to look at the volatility of the VIX. Instruments on VIX and references to VIX will reflect a clearer picture of general risk perceptions than equity market volatiltiy on its own, in general.

In Figure 4 we look at the realised volatility of the VIX; we perform a regime based analysis to demonstrate different market perceptions of risk. It is clear that the VIX itself is currently in a low-volatility regime, i.e., the market’s are fairly confident about volatility (and derivatives thereof) remaining low.
 

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In Table 1 we demonstrate typical perceptions of markets in different regimes of VIX and the volatility of VIX. 

The question that we need to answer is why equity market volatility (and risk perceptions) are currently at their lowest measured levels in decades? Figure 5 is instructive in this regard. We compare the VIX equivalents for the equity, bond, and currency markets – it is interesting to observe that all asset classes are trending to multi-year low volatility levels.

Typical drivers of equity market volatility will be the economic and business cycles, the economic environment, geopolitical risk, economic policy uncertainty, and risk perceptions. The low levels of VIX, currently, seem to be at odds with equity markets at new highs, price/earnings multiples at decade highs, economic policy uncertainty at its highest measured levels, and rising geopolitical tensions amidst rising interest rate concerns and direction. We have to increase our risk-vigilance and wonder if the markets are not complacent – perhaps volatility (or the lack thereof) will identify the skunk!