FT Alphaville More thoughts on whats behind low volatility

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More thoughts on whats behind low volatility
Posted by Izabella Kaminska on Apr 14 18:44.

Weve pondered before why volatility is currently so low .

One theory we presented was the rise of new strategies to fund tail-risk protection, focused on long-dated far out of
the money options, funded by options sales nearer the front.
But here are some more thoughts on the matter as it pertains to the rate market, this time from Bank of America
Merrill Lynchs Liquid Insight report on Thursday.
Our emphasis:
While fiscal issues are a long-term concern for the US rates market in the form of increased issuance in
the future, in the near term it is possible that the market could start worrying about lower growth.
We believe it is worthwhile to consider buying some protection for lower yields. In this context, it helps
that implied volatilities have continued to decline as realized volatility in the recent past has been low.
One additional reason for low implied volatilities is the sale of gamma as an alpha
strategy by investors. As dealers get long gamma and delta hedge their positions, realized
volatility becomes low. In addition to low levels of volatility, the steepness of the yield curve means
that carry and rolldown on long receiver positions is still quite attractive. This combination of a steep
yield curve and low implied volatility levels has made it an opportune time to buy downside protection
in rates.
In other words, a lot of people are selling gamma to generate alpha. In English that could be understood as
unprecedented levels of volatility selling via many different options strategies possibly on the notion that the
Bernanke put will keep volatility contained.
The strategy depends specifically on collecting premiums, rather than anything connected to underlying moves in
stocks or indices. A bit like picking up pennies in front of the proverbial steamroller.
But obviously to work, it also needs a dedicated base of non fussy buyers of volatility or those prepared to fund the
gamma sellers premium based strategies.
Those hedging Vix products are plausible suspects. Indiscriminate flows and buying from such funds may in fact be
facilitating the gamma selling strategy something which may be pushing volatility lower, while encouraging
further delta hedging in Vix futures, which consequently is steepening the general Vix curve as well as the S&P 500
at-the-money term structure.
But the real point is that almost everyone appears to be short spot volatility, and potentially delta hedging via longer
dated tools.
Which could mean that the wider market has decided to cash in on the Bernanke put too, writing options of its own
while it can.
The implications of all this are notable. As Artemis Capital Management, a volatility-focused investment
management firm, recently wrote in an excellent note which asked whether volatility could be broken:
The artificially low volatility in markets may contribute to a dangerous build up in systemic risk.
Many investment banks and hedge fundsuse volatility as an input to determine leverage capacity.
When the Fed artificially depresses spot volatility it produces a feedback loop whereby large banks
can increase their appetite for risk, increasing assets prices, and further lowering volatility. It should

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be no surprise that NYSE margin debt is at its highest level since July of 2008
The papers author Christopher Cole further agrees that things like steep volatility term structures are not normal
and refer to the bizarre break-out of variance the volatility of volatility as used in portfolio insurance.
Indeed, while realised volatility, implied ATM volatility and the VIX are all low, the cost of variance swaps and
volatility options remain at elevated levels versus norms, something which is now starting to compromise returns on
volatility insurance policies.
Artemis, luckily, has some clear thoughts about whats causing all of this, some of which echo our own observations
above.
1) Changes in the supply/demand dynamics of volatility:
Recent structural changes in the supply demand dynamics of volatility may be
contributing to the distortions reflected in todays vol surface.
First, a liquidity shortage on the long-end of the OTC volatility surface emerged as sophisticated
players covered short positions following substantial losses on volatility derivatives in May (less
supply).

2) A preference for longer-dated volatility hedging is emerging and also changing the demand picture:
Secondly, there has been a recent proliferation of new tail risk or black swan hedging
strategies that have increased the demand for long-dated volatility and far out-ofthe-money options (more demand).
3) Gamma selling is rife:
Thirdly , as margin debt has expanded many funds are now shorting spot volatility and buying
long-vol to collect pennies from underneath the proverbial steamroller (short-term supply, long-term
demand).
Which makes us wonder if variance swaps are now a better indicator of market fear than spot Vix.
Related links:
Vix wagging FT Alphaville
Bernankes genie released FT Alphaville
Why is the Vix so low? FT Alphaville
Volatility as the new Black-Scholes FT Alphaville
This entry was posted by Izabella Kaminska on Thursday, April 14th, 2011 at 18:44 and is filed under Capital markets,
Commodities. Tagged with Artemis, variance swaps, vix, volatility.

Comments
Interesting article. I don't think the point is that volatility derivatives are driving spot vol, as much as it is that the vol-surface/skews
are showing risks that are not being fully reflected in ST volatility. While it's true that vol surfaces have been steep in the past, but
not THIS steep when implied volatility is equally as high. Cole makes this point in the research paper, but also argues gov stimulus
is behind lower realized vol. I think there are a lot of people, myself included, who just don't feel right about how variance is
behaving in this environment.

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Implied volatility is best thought of as a *dependent* variable, tethered to equities through actual (historical) volatility. The US
equity markets are varying less: vol traders are not going to wag the dog enough to make more than temporary swings in actual
volatility. Strong derivative markets will always influence underlyings, but it is a stretch at this stage in our history to assume the vol
markets drive underlying volatility. Implied volatility at spot is not low- it is high relative to real (historical) volatility, consistently so,
to the point where it's been very profitable to trade off the difference for awhile. Trying to figure out why it should be even more
unreasonably high seems off the mark. It mystifies me a bit to be referring to "artificially low [implied] volatility" when historical
volatility is where it is.
It is true that tools are getting more sophisticated, that there is lots of gamma selling going on, that people are doing vol calendar
spreads on a steep curve. To me, the more interesting question is: why do the US equity markets display such stability now, an
almost mean-reverting personality the last 4 months? There's the Bernanke put, the overall liquidity strength (buyers and corporate
coffers), and the increasing sophistication/specialization of liquid hedging derivatives and ETFs- what else, I wonder? Or are those
dimensions just very powerful?
Re variance swaps, our tradeable proxy for vol of vol- they'll always provide a better indicator of market fear in a sense, because
they are not only highly auto-correlated with volatility, but they move much faster and provides term structure differentials when
volatility is shifting. When we say 'market fear', we often really mean 'look at how market fear is changing'.
Re the steepening vol surface- I've been expecting and trading it as it went up, ever since the flat curve early this year burned the
long-dated short vol traders so badly. After all that, it's a very natural response for short vol traders to lower their hands and force
up the long end, jack up variances to something that doesn't kill them if we spike to a 30% VIX again. I'm selling to those buyers of
the long-dated vol you mentioned, but I wasn't going to do it unless I got paid for the risk, i.e., until I got some term structure.
Cole's mistaken about steep vol term structure, also: it's been quite common through the years, and is moreover a rational
tendency, given the incredible variance possible and historically evident. After all, vol term structure is essentially a series of
embedded call options on 30 day vol: a few big market wiggles in a row teach traders to build in pricey embedded options for
awhile, especially during rapid vol deflations like now.

When the steamroller stops, somebody ends up out of the money unless they have a nimble strategy. The demand for long-dated
volatility and far out-of-the-money options might imply a concentration of risk in a few players rather like the monolines. The
feedback loop with the banks is perhaps what worries me most, because when it unwinds someone will be left holding the bag,
most likely the tax payer or pension holder. It all looks like a one way bet, rather like houses prices always rise, except they dont
with the latest example being house prices in Beijing. This is what happens when your central bank policy of QE is too
concentrated, too big and too long with a reduction in any of those three perhaps producing a better result.

This is one of the best, and certainly most sophisticated explanations I've seen on the subject! I wrote an article, though targeted to
a much more 'main street' audience and published yesterday on SeekingAlpha, that addressed the 'vix-ation' of the low levels of
vol. (http://bit.ly/epJqcB)
Taken together, the issue seems more understandable.
Your conclusion re 'variance swaps' seems spot on considering the collective comments sited.
Well done.

I remember when people used to actually buy these things called stocks.
People would carefully examine a business to make sure it had a good future and was for sale at a fair price, Then they would buy
a tiny part of this business and hold on to it for a long time.
You paid a commission to buy them but then you never had to pay another one until you sold. You didn't have to pay any taxes
until you sold them either!
Sometimes these stocks would actually pay you money to hold them!
The really nice thing about them is that the management of these companies would work really hard to make the stocks go up.
If they went down, everyone would panic and work really hard trying to make them go back up.
In fact, if they went down, the government would borrow trillions of dollars to try and make them go up again!

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