Thursday, May 4th, 2017

Bi-Modality

We read lots of discussion about the current ultra-low level of volatility in the US, which is a theme we first mentioned in January. Most of it is framed as discussion about the Vix index, but we prefer to talk about realised volatility because we think it is a broader measure of investors’ experience of risk. It is also the single the most important influence on the pricing of implied volatility.

Figure 1 shows the frequency distribution of realised weekly volatility for the S&P 500 from 1995 to 2016. Most investors understand that realised volatility is not normally distributed and would expect to see a long tail on the right side of the distribution, where there are a small number of extreme readings. These have important implications for the maximum loss which US Equities are exposed to. However, investors may not know that the distribution is also bi-modal. It has two peaks – one at 10.5% and the other at 16.0% and there is a big valley between them. The median observation, which is 14.5%, has a much lower frequency than the two modes and their surrounding levels.

This is important because it suggests there are two separate regimes for realised volatility rather than one continuous one, and this will influence implied volatility as well. So, the question for investors is not just whether volatility will rise in the near future, but how likely is it to switch from one regime to the other.
So far we have focused on the US equity market, but the distribution of realised volatility is not the same in other developed equity markets, such as the UK or the Eurozone. The mode for the UK is 8.5%, but the next three highest frequencies come at 11.5%, 13.5% and 17.5%, and none of the intervening valleys are as deep as in the US. The median observation for the Eurozone is 17.0%, which is quite close to the mode at 16.0% and the distribution is more or less normal, apart from the expected right-hand skew. The same is true for Japanese equities, but with slightly different numbers.

If there are two regimes in the US, this makes it different from the rest of the world. Investors should be aware of this, even if we can’t explain it. One possible explanation would be the existence of a group of agents who tend to seek protection when equities are volatile and their solvency cushions are low, but who switch to selling protection and receiving a premium when volatility is low, and their balance sheets are “whole”. It would not be surprising if more of these agents were operating in US financial markets than elsewhere.

Disentangling this behaviour from the actions of the FOMC is beyond the scope of this article. However, we have always believed that the primary transmission mechanism of QE was not the suppression of bond yields stimulating investment in the real economy, but the provision of abundant liquidity, allowing financial intermediaries to hang on to impaired investments, thus reducing financial market volatility. It seems likely that a group of sophisticated agents who are prepared to buy and sell volatility, would also understand this. The danger is that they all stop selling protection, and start buying it at the same point in this hiking cycle. An incremental change in Fed policy could cause a non-linear move in implied and realised volatility. The data suggest the US is more susceptible to this than other markets.

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