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Is S&P Volatility Overpriced?

By Robert Hunter

Anyone even remotely familiar with the global equity markets knows that the past three months have been unusually volatile. In fact, excluding the October 1987 crash, the third quarter of 1998 witnessed the highest three-month volatility level since the 1940s. Perhaps more worrisome for equity hedgers, however, are the current levels of long-term implied volatility, which, according to a Goldman Sachs research report titled “The ‘Rally' in Index Risk: Dimensions, Causes and Opportunities,” suggest that the market has overreacted strongly to the latest round of equity market volatility—to the detriment of volatility buyers.

More than 19 percent of all trading days between July and October witnessed moves of greater than 2 percent in the Standard & Poor's 500. Moreover, the phenomenon was global in scope—the Financial Times/S&P World and Europe indexes posted volatility numbers of 22.7 percent and 27.3 percent, respectively, during the period. And correlation between international equity markets increased sharply as well, offering investors fewer places to hide. Volatility increased by more than 50 percent in the third quarter in all major markets except in Italy, which had experienced high volatility in the second quarter as well.

Will the sky fall?

Despite this breathtaking market volatility, the report argues, one-year implied volatility is higher than it should be. In the United States, for instance, one-year implied volatility has been trading in the 30 percent to 35 percent range, which suggests that “the market is expecting either a crash or a depression-era market environment.” In Europe and Japan, one-year implied volatilities are trading even higher—45 percent on the DAX index and 38.1 percent on the FTSE as of early October.

There are two implications of these high volatility numbers—either the market is pricing into one-year options the expectation that equity markets will move by 2 percent to 2.5 percent per day for the next year, or the market expects a massive shock event in which the market will move by 10 percent to 20 percent in a single day. (In 1987 the market dropped by 21.8 percent; in October 1997 the market dropped only 7.2 percent).

Short-term players who use delta-hedging and market-neutral techniques are hamstrung by such conditions, of course, and are forced to pay higher premiums to preserve their trading strategies. But long-term investors—natural volatility sellers such as pension funds and high-net-worth investors, among others—may do well to take on more short-term volatility exposures to reap the rewards of higher premiums. Those with a neutral market view, says the Goldman report, could sell out-of-the-money puts against cash holdings and simultaneously sell out-of-the-money calls against equity holdings. Bearish investors can buy put spreads (spreads consisting of long and short positions on the same underlying) or put spread collars (strategies that eliminate downside risk and upside participation), while bullish investors can sell at-the-money puts or ratio call spreads (spreads in which the number of contracts purchased and the number of contracts sold are not equal). But despite the attractiveness of the market to volatility sellers, the report notes, “they have yet to take advantage of these high premiums. Instead, market prices are being driven primarily by those needing to trade in the current turbulent market conditions to keep their positions market-neutral.”

Another indicator that the market expects severe downside shocks in the next year is the fact that the volatility skew—the spread between implied volatility for out-of-the-money put and call options—has widened significantly, even considering today's high volatility. Far-out-of-the-money puts are drastically overpriced because they represent the best way to protect against a severe shock, and are thus more attractive in today's volatile climate. The report notes, moreover, that traditional hedges such as put spreads, in which downside protection is provided for the area between put strike prices, are much less expensive now than they were a year ago—a clear indication that far-out-of-the-money protection is on everyone's mind these days.

After the crash of 1987—by all accounts a decidedly low-probability event—long-term out-of-the-money puts began reflecting a “volatility premium” to protect sellers from a similar market event. The Goldman report sees this continuing: “We are likely to see an increase in expected correlation factored into volatility estimates in declining markets,” it notes. “This will further increase the volatility skew incorporated into risk scenarios for financial firms and broadly diversified portfolios”—keeping far-out-of-the-money options more expensive than history indicates they should be.

Spooked markets

Why is the market, in the report's words, “overreacting” to the current eco- nomic milieu? The answer lies in shifts in risk tolerance and correlated risks. The report says that recent wild volatility resulted from the exposures of global financial institutions to emerging markets—particularly Russia, which experienced currency and credit crises—and hedge funds such as Long-Term Capital Management, whose positions were vulnerable to the massive macroeconomic changes that the emerging markets wrought. The result: “a vicious retrenchment in the willingness of investors worldwide to take on risk.”

In addition, these investors acted in unison to sell off their riskiest positions in each asset class as quickly as possible—what the report calls “global deleveraging”—before natural buyers emerged. Potential buyers, in fact, were more than willing to sit on the sidelines and wait out the market turbulence. The report connects these factors to the bailout of LTCM: “The rescue of LTCM can be seen, in part, as an attempt by a group of investment banks to dampen this overreaction by stepping in to take risk while others were holding back.”

The report offers another explanation for high implied volatility: the impact of more than one market shock. Rather than pricing merely a single event such as the 1987 crash into long-dated equity options, the market may be accounting for a shock and several “aftershocks,” including short market reversals. The report notes that the impact of a 15 percent shock event on one-year historical volatility is 6 percent. But if reversals are accounted for, long-term volatility increases even more. For example, an initial six-month implied volatility level of 25 percent becomes 37 percent when a 15 percent shock occurs without reversals, but moves up to 40 percent when reversals are considered.

Bad news for hedgers

Will volatility continue to skyrocket? Not likely, says the Goldman Sachs Volatility Forecast (see table, below), which draws on the Black-Litterman risk model. In every instance, the Goldman prediction of the real volatility level in the fourth quarter is drastically lower than the market's prediction. The result: hedgers will likely continue to overpay for their peace of mind.

For a copy of the report, call 212-902-2908.

The Market vs. the Goldman Sachs Volatility Forecast
The market's predictions of volatility in the fourth quarter, as expressed in three-month implied volatility at the end of the third quarter, differ greatly from Goldman Sachs' predictions.
  Three-Month Implied Volatility Goldman Sachs Estimate (10% decay)
Country end of 98Q3 three months ago % change end of 98Q3 three months ago % change
United States 31.0 18.3 12.7 21.1 16.7 4.4
United Kingdom 37.5 21.9 15.6 20.1 16.0 4.1
France 42.5 24.4 18.1 25.7 20.6 5.1
Germany 44.0 25.3 18.7 27.4 21.7 5.7
Switzerland 42.0 23.0 19.0 26.3 19.3 7.0
Netherlands 42.0 23.5 18.5 27.3 23.2 4.1
Spain 51.0 28.5 22.5 33.1 23.4 9.7
Italy 51.5 33.0 18.5 32.3 27.6 4.7
Japan 38.9 26.3 12.6 23.0 23.1 -0.1
Hong Kong 45.0 44.2 0.8 44.5 45.2 -0.7
Source: Goldman Sachs

Morgan Stanley's Greatest Hits

Research reports are usually ephemeral things that rarely bear a second glance. Morgan Stanley's recent collection of some of its best derivatives research reports is a notable exception. Global Equity and Derivative Markets Risk, a 308-page report that resembles a large softcover book, presents readers with a compendium of articles from the past three years that sketch out the ABCs of risk management in remarkably accessible language. The articles, mostly written by current or former Morgan Stanley employees, are arranged in three sections, in order of increasing complexity. Lisa Polsky's “An Overview of Risk” lucidly outlines the increasing importance of risk management in an ever-more-correlated—and volatile—financial world. The second article in the book's first section, “Getting a Grip on Risk,” urges readers to define, measure and manage their risks, and includes an introductory explanation of the various types of risk and the tools used to manage them.

Section II, “Risk Measurement,” details strategies for portfolio risk measurement, and includes discussions of correlation, tracking risk and dynamic asset allocation. The section also takes on volatility, and in the second subsection delves fairly deeply into options risk, offering concise, coherent descriptions of delta, gamma, theta, rho and kappa.

In “Risk-Adjusted Returns,” the third subsection in Section II, Morgan Stanley's proprietary interests come into focus. After a cursory description of one risk-adjusted return measure—the Sharpe ratio, which dates to the 1960s—in the first article, the remainder of the subsection completely avoids discussion of risk-adjusted return on capital and other measures, and instead focuses on Morgan Stanley's M-squared model.

The final section, “Risk Management,” ups the technical ante, progressing from overviews of risk models and a chapter on value-at-risk to a sophisticated discussion of Algorithmics president Ron Dembo's mark-to-future model, which considers equity, market and liquidity risks, among others. The section continues with a subsection on hedging, including descriptions of flexible collars and techniques to hedge imperfect baskets and manage currency exposures, and a subsection on execution that offers tips on seeing a deal through from inception to completion.

For a copy of the book, send an e-mail to the book's editor, Robert Krause, at qsquery@msdw.com.

Making the Inc. 500

The derivatives software industry has experienced phenomenal growth in the past five years, but three companies—Triple Point, FNX Ltd. and Micro Modeling—have distinguished themselves by making it onto Inc. magazine's annual “Inc. 500” list. This year, Triple Point came in at No. 52, Micro Modeling at 359 and FNX at 434.

While most entrepreneurs would love to boast a five-year growth rate of 100 percent, the companies on this list would consider that kind of success small potatoes. The lowest-ranked company in this year's survey had a five-year growth rate of 625 percent, and Triple Point, Micro Modeling and FNX did far better. It's important to note, of course, that other derivatives software firms may have been able to make the list, but chose not to disclose their sales figures.

Rank Company Sales Growth 1993–97 (% increase) 1997 sales ($000) 1993 sales ($000) No. of employees 1997 No. of employees 1993 Year founded
52 Triple Point 3,279 8,211 243 33 2 1993
359 Micro Modeling Associates 814 29,150 3,191 234 31 1989
434 FNX Ltd. 717 17,600 2,154 146 26 1992