Central bank actions have for the most part suppressed market volatility since the financial crisis of 2008. This is part of a deliberate strategy to lower risk, which is measured by volatility. Reduced risk, it’s hoped, will facilitate borrowing to boost growth. Yet these measures have failed in their primary objective, instead encouraging speculation — which now exerts significant influence over markets and prices.
Artificially low volatility has driven a wide range of investment strategies which generate small returns under stable conditions but are vulnerable to large losses under stressful conditions. Depending on how it is measured, an amount of more than $2 trillion and as much as $8 trillion may be exposed in this way.
The strategies themselves vary. Investors including institutions, mutual funds, hedge funds and high-net-worth individuals explicitly sell options to generate premium income either directly or using call- and put-writing programs.
Many popular fund strategies implicitly sell options. For example, risk parity programs allocate funds across different assets using quantitative models. As risk, measured as volatility, declines, portfolios are biased towards riskier assets. If volatility increases, portfolios favor safer assets including bonds and cash. In addition to the price exposure to the underlying assets, the strategy assumes the risk of changes in volatility as well as the correlation between the assets, both of which can be highly variable. Many common quantitative strategies, like risk premia, commodity trading advisor funds and factor investments have similar dynamics.
Private investors also have purchased large volumes of structured products that promise high coupons in return for selling options on shares, rates, currencies or commodities. Many of these structures embed exotic options, including digital or knock-in knock-out options.
“ Companies with active share repurchase programs funded by low-cost debt are de facto selling put options on their own shares. ”
The largest exposure is via share buyback programs and risky corporate debt, which entail implicit sales of options. Companies with active share repurchase programs funded by low-cost debt are de facto selling put options on their own shares. Since 2009, the purchases, totaling about $4 trillion, account for as much as half of all earnings-per-share increases and around one-third of price gains. Reduction in shares outstanding and increased debt makes firms vulnerable to volatility increases such as that resulting from an external shock like the coronavirus pandemic.
Purchase of risky debt equates to selling a put option on shares of the issuer. Where the firm’s asset value falls below the level of outstanding debt, equity is wiped out and the losses transferred to creditors. This is most evident in riskier, more leveraged companies. In recent years, the largest growth in borrowing has been in the lowest investment grade categories, high-yield debt and leveraged loans.
The explicit or implicit sale of options poses significant risks. Higher volatility translates into losses. In the first place, there is a mark-to-market loss, particularly with sold options. This affects explicit sold options but also in cases where the optionality is implicit. For example, higher volatility increases the risk of default of leveraged companies, which translates into wider credit spreads causing mark-to-market loses for holders. Volatility also increases debt costs and affects the ability to refinance borrowings.
Bigger losses come about due to the need to rebalance portfolios, known as gamma risk. In effect, if there is a large movement in asset prices, that is, real volatility, then portfolios based on selling options must be rebalanced. This typically requires pro-cyclical trading, selling when markets fall and buying when markets rise. This exacerbates market gyrations.
The position is worse where, as generally happens, under conditions of instability, prices jump or are discontinuous. Rebalancing cannot occur as prices change but with a time lag, which means that losses are larger. For exotic options, the rebalancing risk can be huge.
The explicit or implicit use of options entails leverage. For example, in 2018, a dislocation in a $50 billion market of volatility funds resulted in an estimated $5 trillion overall loss in global stocks — although in this case much of the losses were recovered provided positions had not been liquidated.
Volatility works in conjunction with liquidity and the level of interest rates. Cheap and abundant money and low rates dampen volatility and increases the values of risky assets. If credit conditions tighten and rates increase, then it feeds into higher volatility, setting off a chain of losses.
The exposures are linked through complex feedback loops. Increasing volatility causes losses and triggers rebalancing, which amplifies price and volatility moves. Destabilization of credit markets feeds into the first loop, for example, reducing stock buybacks and general risk aversion, heightening volatility shifts. Investment losses lead to fund withdrawals, which adds liquidity pressures into the mix.
Volatility, correlation, and volatility-of-volatility are important because they highlight how distorted economic reality has become. Savers and those charged with managing people’s savings simply can’t meet hurdle rates of return in this environment. They have deliberately or unwittingly taken on additional risk to avoid seeing their purchasing power devalued. These investments may provide short-term excess returns but contain hidden fragilities that may be ruthlessly exposed in the near future.