Robert Engle on Volatility in Financial Markets
Professor Robert Engle, Director of the Volatility Institute, was recently asked for his thoughts about the current market volatility. His response is below.
“Do you think the current episode of stock market volatility has a particular message, or is it part of a larger pattern?”
I believe it is human nature to think that current volatility in financial markets is especially severe. I hear my students and audiences remark on high market volatility even in the midst of the long periods when volatility measures are very low. Fortunately we can use quantitative measures to observe the swings of volatility from high peaks to low valleys and back.
Market watchers have been observing the extraordinarily low measures of volatility of many financial assets for almost a decade following the financial crisis of 2008. Is this a new regime and is it a result of government regulation and stabilization? In February 2018 we learned once again that when volatility is low it will eventually rise. After all, volatility reflects the new information that becomes available about the value of assets such as stocks and this information flow fluctuates. In February we learned that the Federal Reserve was determined to raise interest rates and the market would have to adjust. Later, the president threatened trade wars that would hurt many US companies. The volatility was a natural response to this new information. Similar shocks followed the British Brexit vote, the US withdrawal from the Trans-Pacific Partnership, the great financial crisis and the European sovereign debt crisis. As a volatility observer, I can see how news impacts all of the countries in the world, much as a doctor looks at an EEG. This is a fascinating way to follow and interpret economic news.
There is, however, an interesting new development that has stimulated much discussion. Because volatility has become a traded asset, there is a possibility that trading has a direct effect on the volatility beyond the news itself. The most widely followed volatility measure is the VIX and there are now highly liquid futures traded on the VIX. These futures are now used as assets for exchange-traded funds (ETFs) and exchange-traded notes (ETNs) on volatility. A very popular ETN was XIV, which was an inverse exchange-traded note on short-term VIX futures. This made money as volatility fell and even when it was constant. However, it was always clear that if volatility were to rise, XIV could fall dramatically and, since an ETN cannot become negative, it could go to zero. An ETN is a debt contract and can therefore be called by the issuer. On Feb 5, 2018, XIV’s value essentially dropped to zero and it was called by Credit Suisse, which terminated the ETN. I remember the expression: “Selling volatility is a profitable short career!” Did trading cause the volatility? I don’t think so but it may have made the rise more rapid than it would have been otherwise.
In spite of new technologies, stratospheric levels of asset prices, and changes in political and regulatory regimes, the rise and fall of volatility around a stable level remains one of the most extraordinary features of financial markets.
