Global Financial Tumult Heightens Awareness of Volatility-as-an-Asset

By January 31, 2016 Newsletter No Comments

Higher market volatility, slower economic growth and Global Financial Tumult. That’s the main takeaway from the International Monetary Fund’s revised Global Economic Outlook, which was released in January against a backdrop of financial chaos that pushed Chinese and European equities into bear market territory in the first two weeks of 2016.

Increased volatility is “here to stay,” according to Mohamad El-Erian, Chief Economic Advisor at multinational finance company Allianz. Commenting on the latest bout of volatility in a January 19 Bloomberg article, El-Erian adds that the global financial markets are shifting from a period of repressed financial volatility to an environment where such instability is higher and far less predictable.[1]

In finance, volatility measures the underlying risk of a particular security or market and is used to estimate fluctuations in price over a short period.[2] Volatility can be measured by using the standard deviation or variance between returns from that security or market index, helping investors determine the extent to which the return of an asset will fluctuate over time.[3]

In general, if a security or market fluctuates rapidly over a short period, it is said to have high volatility. If the price fluctuates slowly, it is said to have low volatility. As you can imagine, periods of low volatility usually result in more stable and predictable trading environments.

In today’s financial climate, volatility is an incredibly important tool for understanding market fluctuations and investor fear. Volatility has been described as a “new asset class” for savvy investors looking to capitalize on irrational behavior and prevailing uncertainty in the market. That’s why more and more market participants are paying attention to the Chicago Board Options Exchange’s Volatility Index (VIX), which was introduced in 1993 as a means to gauge market expectations of near-term volatility. The CBOE introduced a new VIX index in 2003, enabling volatility to be traded on the open market.

Today, VIX investment products can be traded via futures contracts, options and exchange-traded notes (ETNs).

The VIX, also known as the “investor fear gauge,” measures implied volatility of S&P 500 index options over the next 30 days. The indicator itself is quoted in percentage form and fluctuates throughout the day, giving investors a real-time snapshot of market volatility. It maintains a historical average around 20, which means that values below that level correspond to periods of low volatility. Values significantly above 20 indicate higher amounts of volatility in the market.

According to an independent analysis conducted by Goldman Sachs, a VIX reading in the high-20s to low-30s usually corresponds to recession-level volatility.[4] This is important because the VIX reached those levels in late August following the “Black Monday” market crash, reaching a closing high of 40.74 on August 24, the highest level since September 2011. It would remain above the historic level for another six weeks.

Since the inception of the VIX index, several other volatility indices have sprung into existence. Some of the most popular are the EURO STOXX 50 Volatility Index (VSTOXX), the German DAX Volatility Index (VDAX), the SIX Swiss Exchange Volatility Index (VSIX) and the Nikkei Volatility Index (JNIV).[5] The CBOE offers volatility indices for US stocks, non-US stock ETFs, interest rates, commodity-related ETFs and currency-related ETFs, giving investors wide exposure to the markets.[6]

With US stocks posting their worst two-week start to a year on record, 2016 is shaping up to be a highly volatile year for Wall Street. US corporations are mired in an earnings recession for the first time since 2009 and are on pace for their third consecutive quarter of profit decline. Meanwhile, uneven global demand and a surging dollar are making it difficult for US corporations to increase international sales and profitability.[7]

It’s also clear that investors can no longer rely as much on monetary stimulus to suppress market volatility. Central banks are either unwilling (in the case of the Fed) or unable (in the case of the PBOC) to calm the markets.[8] This means that volatility will remain in the foreground for much longer, perhaps resulting in a larger decline in equity prices as a whole.[9] All of this is to say that the VIX Volatility Index could provide unique opportunities for investors in this period of heightened uncertainty.

[1] Mohamed A. El-Erian (January 19, 2016). “The Deeper Causes of the Global Stocks Rout.” Bloomberg View.

[2] The Economic Times. Definition of ‘Volatility.’

[3] Investopedia. Volatility.

[4] Jim Edwards (August 31, 2015). “Goldman Sachs says this chart looks like this only when there’s about to be a recession.” Business Insider UK.

[5] (November 2010). Volatility as an Asset Class.

[6] CBOE. Volatility Indexes.

[7] Dan Strumpf (March 22, 2015). “Strong Dollar Hammers Profits at U.S. Multinationals.” The Wall Street Journal.

[8] Mohamed A. El-Erian (January 19, 2016). “The Deeper Causes of the Global Stocks Rout.” Bloomberg View.

[9] Mohamed A. El-Erian (January 15, 2016). “Mohamed A. El-Erian: Market volatility should make us nervous.” The Globe and Mail.

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