Monday, August 31, 2009

Implied volatility update

This chart is meant to add to my previous post. It shows the implied volatility in bond and stock options. Note that vol has dropped significantly from the highs of late last year, but it still remains at elevated levels from an historical perspective. I take this to mean that the market is still very nervous about the future, which is another way of saying that the market's outlook for the economy is far from clear. That's why you see lots of talk these days about a W-shaped (double-dip recession) recovery, or an L-shaped (no recovery) recovery. My point is that this market is not priced to optimism, and is still plagued by lots of doubts and fears. If the economy can mount even a modest recovery, as it appears to be doing, then it will pay to be optimistic.


__ said...

"I take this to mean that the market is still very nervous about the future"

MOVE 3m is an index of 3m implieds. Short dated implieds are largely determined by realised. Realised vol in rates has been relatively high of late: e.g. average range over the summer in the 10y has been 13.2bp and average daily move has been 7.6bp (data courtesy of ML - too busy to check!). I would posit that is why implieds remain high.

If you want to see if the market is still nervous about the future, look at longer-date implieds. The market IS worried, but mostly about high inflation, hence way OTM payers / caps are so bid.

Scott Grannis said...

Good observations. But even if realized vol drives implied vol on short-dated contracts, realized vol is still a good measure of how skittish the market is and/or how much the changing data are causing expectations to shift. In other words, volatile Treasury yields across the curve are an indication of uncertain conditions, and uncertainty is a key ingredient to fears and nervousness.

Public Library said...

Maybe you should throw out the data between half '04 and part of '07 since we now realize this period of time was throwing off massively false signals about risk.

And now that Big.Gov has asserted itself into every facet of the economy, it would be wise to recalibrate your risk tools.

Scott Grannis said...

I think that data is too valuable to throw out. We need to keep it to remind us what an overconfident market looks like. I remember at the time saying to clients that vol was so low that it made me very nervous; something awful was likely to come out of nowhere, but I had no idea what it would be. What made it especially difficult, however, was the length of time that low vol conditions persisted. The more time went by, the harder it was to justify caution.

Public Library said...

Of course. I meant more in terms of this post.

We should all log the past 5 years in the books for later use!

Jay Norman Davis said...


My wife thought that since next year is an election year the Govt. will have to do something to stimulate jobs. She thought one way would be to give breaks to business in order to create hiring. Any thoughts.

Scott Grannis said...

For the moment, tax breaks for business don't appear to be on the Democrats' priority list. That could change, however, as the elections approach but the economy fails to stage an unemployment-reducing recovery. I'm hoping that there is a change in the political winds that puts more emphasis on giving businesses incentives to create jobs, and less emphasis on redistributing income (see my subsequent post to this).

So it doesn't look very likely now, but I don't think you can rule it out. There has already been a sea change in the political landscape in the past seven months, and the elections are still over a year away.