We are now looking at the limit of market volatility and this is deeply reducing

Artificially low volatility has fueled a wide range of investment strategies that generate small returns under stable conditions, but are vulnerable to large losses under stressful conditions. Depending on how it is measured, more than $ 2 billion and up to $ 8 billion can be exposed 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 through buy and sell programs.

Many popular fund strategies implicitly sell options. For example, risk parity programs allocate funds to different assets using quantitative models. As risk, measured as volatility, decreases, portfolios are oriented towards more risky assets. If volatility increases, the portfolios favor safer assets, notably bonds and cash. In addition to the exposure to the price of the underlying assets, the strategy involves the risk of changes in volatility, as well as the correlation between the assets, which can be very variable. Many common quantitative strategies such as risk premiums, commodity trading advisory funds and factor investing have similar dynamics.

Private investors have also purchased large volumes of structured products that promise high coupons in exchange for the sale of stock, rate, currency or commodity options. Many of these structures incorporate exotic options, including digital or direct destruction options.

The largest exposure relates to share buyback programs and risky corporate debt, which involves implicit option sales. Companies with active low-cost debt-financed share buyback programs de facto sell put options on their own shares. Since 2009, purchases, totaling approximately $ 4 trillion, have accounted for up to half of all increases in earnings per share and about one-third of price increases. The reduction in outstanding shares and the increase in debt make companies vulnerable to increased volatility, following an external shock such as the coronavirus pandemic.

The purchase of a risky debt is equivalent to the sale of a put option on the shares of the issuer. When the value of the company’s assets falls below the level of outstanding debt, equity is eliminated and losses are transferred to creditors. This is most evident in riskier, more leveraged businesses. In recent years, the strongest growth in lending has been in the least creditworthy, high yield, and leveraged investment categories.

Significant risks

The explicit or implicit sale of options involves significant risks. Greater volatility translates into losses. First, there is a loss of market, especially with the options sold. This affects options sold explicit, but also in cases where the option is implied. For example, increased volatility increases the risk of default for leveraged companies, which results in larger credit spreads that cause market losses for holders. Volatility also increases the cost of debt and affects the ability to refinance loans.

The largest losses are due to the need to rebalance the portfolios, known as gamma risk. Indeed, if there is a significant movement in asset prices, that is to say real volatility, the portfolios based on put options must be rebalanced. This usually requires procyclical trading, sales when the markets go down and purchases when the markets go up. This exacerbates the turns in the market.

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The situation is worse when, as usually happens, in unstable conditions, prices rise or are discontinued. Rebalancing cannot happen as prices change, but over time, which means that losses are greater. For exotic options, the risk of rebalancing can be enormous.

The explicit or implicit use of options implies leverage. For example, in 2018, a dislocation in a volatility market of $ 50 billion resulted in an estimated overall loss of $ 5 trillion in global stocks, although in this case, most of the losses were recovered as long as the positions had not been liquidated. .

Volatility works in conjunction with liquidity and the level of interest rates. Cheap and plentiful money and low rates reduce volatility and increase the value of risky assets. If credit conditions tighten and interest rates rise, this fuels increased volatility, triggering a chain of losses.

Exhibitions are linked by complex feedback loops. Increased volatility leads to losses and triggers a rebalancing, which amplifies price movements and volatility. The destabilization of credit markets is introduced in the first cycle, for example by reducing share buybacks and general risk aversion, by increasing variations in volatility. Investment losses lead to withdrawals of funds, adding liquidity pressures to the mix.

Volatility, correlation and volatility of volatility are important because they highlight the distortion of economic reality. Savers and people savings managers simply cannot cope with the difficult rates of return in this environment. They have deliberately or involuntarily taken an additional risk to prevent their purchasing power from being devalued. These investments may provide excessive returns in the short term, but they contain hidden weaknesses that may be ruthlessly exposed in the near future.