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

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.

Risk

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.

Volatility

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.

Comment

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!
Unbelievable!
Wow! Wow! Wow! Wow! Wow! Wow!
Unbelievable!

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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The “experts” were and indeed are not ready for negative interest-rates

Whilst negative interest-rates are not an outright new phenomenon they are being applied right now on an unprecedented scale. As the Bank of England’s Underground Blog reminds us.

one quarter of world GDP now comes from countries with negative central bank policy rates.

There are a load of consequences from this. Let me open with one which is not publicised as much as it should be. It is that interest-rates (and indeed bond yields) are held down elsewhere by the fact that a rise would lead to currency inflows and likely appreciation as they are compared to the negative rates elsewhere. It has become another component of what has been labelled the currency wars. A feature of this has been the way that the US Federal Reserve has progressed at slower than a snail’s pace in raising US interest-rates as we are nearly in June but have seen so far none of the 3-5 interest-rate rises promised at the turn of the year. Interest-rate rises such as they occur are mostly in response to currency crises these days. By contrast Reuters records this.

Ukraine and Moldova cut rates again today, making it 11 central banks to ease in May alone. 53 since start of last year.

How do people respond to negative interest-rates?

Sweden is one of the nations involved and in fact has the lowest rate so far as whilst the headline is -0.5% the Riksbank also has a deposit rate of -1.25%. This week has seen some news which confirms one of the themes of this blog but first let us let the central bankers have a brief moment of fun in the sun. From Sweden Statistics.

In April households’ loans from Monetary Financial Institutions (MFIs) had an annual growth rate of 7.7 percent, which is 0.2 percentage points higher than in March. Households’ loans from MFIs totalled SEK 3 369 billion.

Central bankers around the world will smile at the way that negative interest-rates have led to a surge in household borrowing. The smile gets even broader when they read a little further down.

The increase is mainly due to housing loans, which increased by SEK 217 billion compared to the corresponding month last year, and amounted to a total of SEK 2 758 billion in April. Housing loans had an annual growth rate of 8.5 percent in April, unchanged compared to March.

So all the Christmases of central bankers have arrived at once it would appear. Cutting interest-rates leading to an economic surge? Er well maybe not as the Shaun critique comes into play. Remember my posts on savings where I have argued that lower interest-rates makes some save more? Well on Monday we got evidence of that.

Households’ financial savings, new savings minus increase in debt, amounted to SEK 58 billion during the first quarter of 2016.

Yes you did read that correctly as the Swedes were net savers in the first quarter of 2016. This is where they put the money.

Households mainly saved in insurance and deposits and made net sales of shares and funds. Net deposits, mainly in bank accounts and tax accounts, amounted to SEK 38 billion, a record level for the first quarter.

The increase in bank savings ( SEK 23 billion) back my argument that cutting interest-rates leads part of the population to save more not less. This offsets the conventional view which only seems to look at the increased borrowing and in this instance ignores the fact that there is net saving going on. Also the plan to get people to shift in to assets seems to be working for houses but not investments “net sales of shares and funds.”

Accordingly we see a complex situation which on the surface seems to back what we might call central banking economics 101. But once we go below the surface we see a familiar argument which is that yes it “works” but that there are offsetting forces which yet again appear to be larger. No wonder central bankers do not always get what they want and struggle to get what they need as well.

They do not apply everywhere

We do not have to step back that far in time to discover a different view of the world from a man who was responsible for much of the work in the derivatives world which provided my occupation and job. From the Bank Underground blog.

n 1995, Fischer Black, an economist whose ground-breaking work in financial theory helped revolutionise options trading, confidently stated that “the nominal short rate cannot be negative.”

You could argue he was already wrong although equally you could argue that Switzerland in the 1970s was a tax on cash especially for foreigners. However let is move on with a number which was not supposed to happen.

According to the BIS, the total notional outstanding of global FX, interest rate and equity-linked derivatives rose from $72 trillion in 1998, to $522.9 trillion in 2015. ( BIS = Bank for International Settlements).

Remember when as the credit crunch hit we were promised that this sort of thing would be curtailed? Perhaps that is why one of the main players, Deutsche Bank, remains so troubled. If we move on we see that there is a link between this and negative interest-rates.

The vast majority (nearly 80%) are interest rate derivatives whose theoretical underpinnings are often predicated on the assumption that risk-free rates are bounded at zero. These baked-in assumptions have made it more complicated for financial markets to adjust to life below 0%, particularly where derivatives were priced and risk-managed as if negative rates were not possible.

That needs to sink in as a group of highly paid people who were are so often told need to be paid so much because they are the “brightest and the best” see their intellectual Titanic hit the rocks and in some cases hard. There have been some technical fudges to help deal with the consequences of this but the market based response was fascinating.

The obvious hedge was to protect oneself against lower rates and higher volatility, for instance by buying bonds, entering interest rate swap contracts, and buying options……However the process of hedging likely amplified the fall in yields,

So problems with negative interest-rates helped lead to negative bond yields! What could go wrong?

Floating Rate Notes (FRNs)

These have had their Houston we have a problem moment.

Legal and operational practicalities have meant FRN coupons are effectively floored at 0%.

Ah, more signs of “genius” at work. This provides yet another problem for central banking 101.

This 0% floor is important. As noted by Ippolito, et al (2016), FRNs are a significant channel through which the monetary policy transmission mechanism works.

Or rather they are not in this instance. The companies involved also have some Taylor Swift style “trouble,trouble,trouble.

But companies must contend with the prospect of having the cost of their FRN liabilities floored at 0%, whilst seeing returns on investible assets fallbelow zero.

This is mostly an issue in the Euro area right now and here is an estimate of the scale.

At present, €350bn of euro-denominated FRNs referencing Euribor (28% of total outstanding) are affected by this 0% floor. If Euribor falls by a further 25bps, we estimate that around half of all EUR FRNs would be affected (~€670bn).

Comment

There is more than a certain irony in the fact that the group who were the supposed experts on interest-rates have been proven spectacularly wrong. We have gone where they argued we could not go. I remember the arguments in the late 90s as I was there but what troubles me the most was the failure to adjust post 2007 which is nearly a decade ago now. We see so little thinking and planning ahead and accordingly the “experts” suffer so many surprises.

What we suspected and believed on here was that negative interest-rates would have a succession of unintended and unwelcome consequences has proven to be true. This matters increasingly as I note this from Robert Skidelsky in Wednesday’s Guardian.

Enter negative interest rate policy. The central banks of Denmark, Sweden, Switzerland, Japan, and the eurozone have all indulged. The US Federal Reserve and the Bank of England are being tempted.

The latter section caught my eye as is they way he was described. Do you think both he and the Guardian had forgotten he is Baron Skidelsky and could not be much more well-connected?