MEASURING THE RISK OF VOLATILITY
When it comes to measuring risk, whether it is that of global markets, specific asset classes, or a single stock, volatility is one of the most important indicators and measurements of risk. Understanding volatility can provide an investor with valuable insight into the performance of their chosen investment instruments or market and its ultimate value.
Volatility, as a measurement of risk, is usually something investors experience during times of market uncertainty, whether that be political risk or related to underlying economic conditions. The importance of volatility has led to the creation of a number of indices that try to forecast the expected variation in future price movements of specific assets or markets. These indices often use option prices - an option is an instrument that gives an investor the right, but not the obligation, to buy or sell an asset at an agreed upon price on a specific date - to gauge the risk within the market as well as other factors which are specific to the asset class in question. Understanding the dynamics of volatility indices and how they relate to the actual asset price movements, is useful in order to improve one’s knowledge of the underlying investment and potential loss or gain from any arising risks or opportunities.
In the USA, the Chicago Board Options Exchange Volatility index (formally known as the VIX), is one of the most monitored volatility indexes in the equity market space. The index collates all the prices of short-term S&P500 options to produce a 30-day forecast of volatility. Option pricing is one of the most effective data points to use when calculating volatility as the price of options increase or decrease based on implied volatility. In other words, if the price of short-term options increases, the VIX would spike, meaning that there is increased uncertainty within the S&P500 equity market over the next 30 days.
From the graph below, it is easy to see that when there is a spike in the volatility forecast of US equity market, the daily percentage movement of the S&P tends to be negative. This is due to growing uncertainty and a rerating of equity prices. Economic indicators such as US manufacturing production or economic sentiment indicators can have varying impacts on the VIX index, but as of late, the geopolitical tension such as the trade war between the US and China has been the main cause for the spikes in volatility. It is therefore important to understand the connection between how economic and political noise has an impact on the markets and future uncertainty of equity prices.
Another cause of volatility leading into 2019 was the growing concern regarding the amount of global negative yielding debt. The US Federal Reserve Bank (the FED) was also in the spotlight about how accommodative they would become around their interest rate policy. As the yield on the 10-year US Treasury note declined below 1.5%, due to the FED cutting short term policy rates, coupled with an increased fear of a global economic slowdown, uncertainty in the global debt market increased. Accommodative monetary policy has led to record levels of total global debt. As yields on developed market debt move lower, primarily based on a lower or negative interest rate environment, higher yielding emerging market sovereign debt has become more attractive. Such an interconnected debt market can therefore cause volatility across the entire global bond market, and will have a great impact on the world’s economy if monetary policy turns less supportive or if inflation returns to developed markets.
The main volatility index measuring interest rate and debt uncertainty is the MOVE index. This index provides signals regarding interest rate uncertainty and overall sentiment on the US bond market. Similar to the VIX index mentioned above, MOVE makes use of implied one-month treasury options across the treasury yield curve (from 2 years to 30-year maturities). In the graph below, it can be seen that during August 2019, the Move index spiked as overall bond market uncertainty increased based on the escalation of the US-china trade war as well as an increase in interest rate uncertainty.
However, the longer-term profile of the MOVE index has mainly declined since the global financial crisis in 2008, as central banks increased the use of quantitative easing and implemented more accommodating monetary policy. It is therefore important to consider the stance of the FED and other developed central bank policy decisions as any slowdown in quantitative easing or the return of inflation can have many knock on effects within the bond market. We have already seen some of these effects, with the US repurchase rate rising as a shortage of liquidity unfolded in September. These signs can only lead towards further dependence on supportive monetary policy.
Foreign exchange volatility is another important consideration for investors as it is an integral part of the global economy. Volatility across currency pairs has remained relatively subdued based on the JP Morgan Global Volatility Index (see below). Like the others, this index also makes use of short-term expiry options to gauge the overall uncertainty across currency pairs. Understanding the global foreign exchange market can be tricky given the number of levers which can pull a currency, relative to the US dollar (USD), higher or lower. The largest factors which drive foreign exchange (FX) market volatility are inflation rate differentials and interest rate differentials, which can cause a currency to depreciate or appreciate relative to the USD.
Another important factor to consider, when it comes to currency volatility, is the movement of capital across borders. Some countries are in different parts of their economic cycles and grow at different rates relative to their peers, for example emerging market countries versus developed markets. If capital can be allocated more efficiently, and therefore earn a higher return, in one country relative to another, the country’s currency will increase in value.
JPM VOLATILITY INDEX
The ever-changing landscape of investment management can result in a number of views on a country’s capital market, which can also lead to currency volatility. The lower FX volatility seen recently is based on a stable USD, more accommodative interest rates and lower volatility in equity markets. This means that the implied volatility has been higher than the realised volatility of most currency pairs. Similarly, it is important to monitor the movement of economic and sentiment indicators of various countries. These indicators have the potential to cause a reallocation of capital which can lead to uncertainty in the global currency market.
Ultimately, it does not matter what asset class or market you are looking at, volatility is an important measurement of risk and should be taken into account when identifying any investment. Various uncertainties and indicators can lead to higher or lower volatility within a specific asset class, which have negative or positive effects on the underlying price of that asset. The above volatility indicators should provide better insight as to how an asset is behaving and how the market’s perception of risk has an impact on the underlying price, and therefore, the value of an asset.