Volatility: looking for the philosopher

10th October 2011

And some banks are now claiming they can give this downside insurance via a complex series of derivatives.

They believe they can protect institutional investors against big falls in their portfolios without having to move those holdings out of equities and into other asset classes. If so, they have found the philosopher's stone, turning base metals into gold.

But no one knows what the knock-on effects will be on these and other portfolios. It could be an expensive process which can produce its own difficult to foresee problems.

It all centres on the VIX, the volatility index traded on the Chicago options market, and which is commonly referred to as the "fear gauge". The VIX is most active when markets are falling without signs of a soft landing, let alone a parachute. The VIX hit 250 in the wake of the Lehman Brothers crash three years ago. Over the past few weeks, it has trended up from a benign 50 to approach 100.

And the sudden movements that have caused the VIX to nearly double, increase the possibility of tail risk,  a phenomenon which, in the guise of fat tail or kurtosis risk can cause panic in the mathematically driven world of complex investment strategies. There's a fuller version of what this involves from Deutsche Bank.

But if the condition is not new, one touted solution is novel. It is to load investors with in effect a volatility of volatility index, according to the Financial Times. This will go long on the VIX (betting it is going upwards, which indicates rocky times) when it is likely to rise sharply but which will move into safer assets such as Treasury Bills when the fear index is trending downwards.

Investors should pose a number of questions.

Does it work? So does it provide the downside insurance they want?

At what cost does it come? So is the expense of cover out of all proportion to the protection provided?

And what happens if the market suddenly turns for the better? So is the insurance designed to be easily ditched?

Buying a derivative based on volatility could increase volatility, which will in turn push up the cost of the cover.

But like so many market ideas, it could work while there are only a few participants. If it became mainstream, it might collapse under its own weight of money.

Henderson Global Investors says the VIX is trending up and is currently at levels last seen a year ago when the possibility of a Greek default first hit the radar.

Leave a Reply

Your email address will not be published. Required fields are marked *