This note from Claudio Irigoyen and others supports the notion that implied volatilities naturally return to long-term trend even if economic uncertainty does not. While implied volatility is very sensitive to deteriorating conditions, actual and implied volatility under poor but stable conditions may be compressed by investor adaptation (defensive repositioning, risk management changes, easing risk aversion, etc.) and policymakers’ direct market intervention (liquidity supply, policy puts, etc.). Technically speaking, the first derivative of economic uncertainty indicators may condition the mean reversion of implied volatility.
“[2012] witnessed a significant decoupling of market volatility and economic uncertainty. Implied volatilities in equities, foreign exchange, fixed income, credit and commodities all reached post-Lehman lows at the end of October 2012.”
“Markets are particularly uncertain about what type of economic policies the leading countries will end up implementing to support growth. This perception of uncertainty is captured nicely by the indices of economic policy uncertainty recently elaborated by Baker, Bloom and Davis for the US and Europe. These indices are constructed by aggregating over three components. The first component is news based that quantifies newspaper coverage of policy-related economic uncertainty. The second is a tax code expiration component that quantifies federal tax code provisions that, as a matter or current law, are scheduled to expire at specific current dates. The third component captures forecast disagreement among economic forecasters. Not surprisingly, the indices show that policy uncertainty is still very high. In fact, current readings are close to those registered during the unfolding of the Lehman crisis.”
- The asymmetric behavior of implied volatility (rising with weak markets but declining with strong markets, regardless of external uncertainty) is reinforced by other structural features and, hence, crucial to understanding the current low volatility and high uncertainty regime.
- Given its state-contingent nature (time varying risk premia), risk aversion increases in bad times, increasing the demand for downside protection. In good times, demand for protection diminishes, so implied volatilities drop and skews compress.
- Liquidity drains in selloffs mean that dealers find it more difficult to hedge the flows of clients when volatility is higher. By implication, liquidity supported market recoveries trigger the opposite
- The increase in correlation during selloffs is also a function of the quality of information and the capacity of the market to filter information in a short period of time to determine the necessity to reduce risk. In a selloff, people sell and then ask questions. The opposite is true in tranquil times; investors think carefully what assets have more value, process the information more efficiently
- In addition, there is a feedback effect between volatility and the unwinding of risky positions, since typically leveraged participants are assigned capital in terms of value at risk, which is itself a function of implied (or realized) volatilities and skews (tails).
