Capital Markets

Low Implied Volatility Should Give Pause

The question is whether the price of uncertainty, particularly in equity markets, will remain as low as it is now.
Economist StaffJuly 27, 2004

There are few beasts in the financial jungle more curious than the market in uncertainty. Traders buy and sell uncertainty as readily as if it were something tangible, like pork bellies or Treasury bonds. Strange though it may seem, it is no exaggeration to say that the price of just about every risky asset in the world depends in part on investors’ perceptions about the price of uncertainty. It is precisely because investors appear so certain about the future that the prices of so many assets are now so high. The opposite holds too, of course. If investors became less certain, those prices would fall.

In financial markets, uncertainty goes under the name of volatility — how much asset prices are moving around. One popular measure of stockmarket volatility, the Chicago Board Options Exchange’s VIX index, has fallen to its lowest since 1996. In August 2002, it soared to 45; this year it has mostly traded between 14 and 16. Interest-rate volatility has also fallen sharply, though not as far.

What most concerns traders and investors is not how much assets have moved in the past, but how much they are expected to do so. In the jargon, this is called implied volatility. It is the number that traders plug into the models they use to price options: the VIX, for example, is an index of implied volatility of options on America’s S&P 500 stockmarket index.

Lately, investors in risky assets of all sorts have been selling options. Whether they think of it this way or not, they have been selling volatility too. “The whole world is short volatility,” says David Goldman, the head of fixed-income research at Banc of America Securities, with a flourish. As volatility has fallen, so investors have raked in profits on those risky assets.

The question, of course, is whether the price of uncertainty, particularly in equity markets, will remain as low as it is now. Markets have become less volatile than they were between the spring of 2000 and the autumn of 2002. Moreover, firms in many countries, particularly America, are swimming in record profits, and the longer the global recovery continues, the more convinced investors become that the good times will continue. Both make for more certain share prices.

But the steep fall in implied volatility is nonetheless a bit odd. There are, after all, many things that could go wrong for financial markets: tensions are still bad in the Middle East; the oil price is again over $40; and the Federal Reserve is raising interest rates when American households are more indebted than they have ever been. (For more, see “Volatility: An Eerie Calm.”)