Volatility – Ubiquitous, Yet Evasive?
by Eben Maré, Portfolio Manager, Stanlib
In this article we discuss aspects of asset class volatility. We look specifically at the VIX index and some of its properties – VIX has become very popular in the media of late, especially with low historical levels being printed. We try to understand its implications.
What is volatility?
Volatility is a statistical measure of the dispersion of asset returns. High volatility levels would typically imply a large spread (or distribution) of potential asset returns when compared to an asset with low volatility.
In essence, volatility is the standard deviation of asset returns measured over some period and typically annualised for comparative purposes.
What are the drivers of volatility?
By definition, volatility is a function of asset behaviour; hence any factor impacting on asset-moves would impact volatility. The following factors would typically impact our views on volatility (note the list is not exhaustive):
1. The economic cycle. Volatility is cyclical – decreases in the unemployment rate in the USA, for example, have been linked to lower equity market volatility.
2. Uncertainty about the economic environment. There has been a lot of academic study of the disjoint between asset volatility and volatility of economic fundamentals – assets are frequently much more volatile than underlying economic fundamentals would justify. It has been demonstrated that periods of lower inflation, for example, have been linked to lower asset volatility.
3. Financial stresses. Recent events such as the 2008 credit crunch and the 2011 European debt situation provide examples of significant asset volatility as a consequence of dysfunctional market dynamics.
4. Valuations. High equity multiples and low bond yields, for example, increase the effective duration of the assets thereby increasing the sensitivity of assets to news-flows which in turn serve to create volatile behaviour.
5. Regulations and policy interventions. Regulations and central bank monetary policies have a direct consequence on asset class volatility – in recent times volatility has been dampened as a consequence of so-called forward guidance and asset purchases by central banks.
What is the difference between realised and implied volatility?
Realised volatility is typically calculated by looking at the standard deviation of historical asset returns over some period. Implied volatility would typically refer to a volatility level implied from the value of a derivative security, such as an option, by making use of an option pricing formula (such as the Black-Scholes option pricing methodology, for example). Market participants like to think that there is some informational content in implied volatility, i.e., a forecast of volatility which could be experienced during the lifetime of the derivative security.
We would frequently look at the difference between the realised and implied volatility to make an assessment of the amount of uncertainty present in the market.
Why do I care?
In modern finance we associate risk with the volatility of an asset’s returns. We would use volatility to aid the estimation of risk premiums and provide an indication of risk appetite for investment decisions. High volatility would typically be associated with high uncertainty and would, in principle, demand higher returns to compensate for the perception of higher risk.
If we use USD/ZAR as a currency example, it has frequently been noted that managers are typically less concerned about the absolute level of the currency than the volatility of currency moves as stability provides more budgeting accuracy.