Deconstructing Vol

The VIX is hovering around 70%. This is an annualized volatility. Bringing it to a daily level, volatility would be about 4.5%. Hence, the VIX is telling us that market moves of up to +/- 9% should not be unexpected.

Market pundits often refer to market volatility as a measure of fear. Let me offer some ideas as to the drivers of this volatility.  

1. Systemic shock to credit spills into the real economy. A systemic shock is something that effects a wide range of markets around the world. We are in the middle of one. Any time you take a systemic hit, volatility will increase. It is assumed that the shock will negatively impact economic growth and corporate health

2. Uncertainty. Sometimes referred to Knightian uncertainty, after the famous economist Frank Knight. Simply put, we understand that there has a been a shock. However, we are uncertain about it implications. There could be a depression, deep recession, mild recession. It is not clear to the market.  

3. Overreaction. When implications are unclear, the markets seize on small pieces of information and sharply move prices. It is extremely unlikely in environments like this that prices are efficient (efficient in the sense of correctly reflecting all available information). Hence, it is likely that prices over-react (and sometimes under-react). The over-reaction is reflected in volatility.

4. Disagreement. This is related to uncertainty. In certain times, there is strong agreement that, say the earnings of firm XYX will be in the range of $0.40 to $0.42. Today, there is huge dispersion of beliefs. This is reflected in volality. 

5. Increased correlation. In other words, fewer diversification opportunities. This is related to systemic shock. If you think about the S&P 500 in usual circumstances, some stocks move up and some move down. There is some natural diversification. This reduces the volatility of the index. But if there is a shock like the credit crisis, almost all stocks begin to move together (increased correlation) which reduces the diversification. This naturally leads to increased vol.

6. Skew risk. Skewness has to do with the size of the tail. Negative skewness means that there is a greater than normal probability of a big down move. While it is possible to track skewness as a separate measure, increased negative skew will manifest itself in higher volatility. 

We often consider the market volatility as related to the risk premium that people require for investing in equities. That risk premium has increased. High risk premiums means that market prices must decline (to make sure new investors get a higher expected return) Given lower cash flows by firms in a recession, there is a second reason why market prices decline.

Understanding the drivers of market volatility, help us understand the possible scenarios that can reduce market volatility. First, and foremost, is the real economy. The market does not know how badly it is hit. Data over the next month will reveal the damage. Second, the market does not know how effective the government actions will be in stemming the crisis. Most of these actions are not implemented. Again, we will need at least one month.  

Hence, we should expect a high volatility environment for at least the next few months. In that time, uncertainty should be reduced, disagreement diminished and hopefully the government actions cut clip some of the tail risk of a deep recession.

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