Volatility art and rhythm

Some days ago a very rythmed video was published by Artmeis CM on You Tube on two decades of volatilities and S&P values.

Volatility has been an issue since the studies of Markowitz in the late 50s who, from an operational research perspective, brought the idea of optimizing the risk-return pair, i.e. maximize the return for a given level of risk or minimize the risk for a desired level of return. And "risk" was mapped to the notion of standard deviation or volatility. Now, volatility represents a measure of dispersion around the trend that you are following, and is synonym of "uncertainty" first - today, we know that risk can be much more than just volatility. And therefore, a low volatility does not mean necessarily "good news": a rapidly declining market can show a low volatility if there are strong beliefs about the declining trend.

Since the 70s, volatility then became a key input parameter to the valuation of options, i.e. insurance contracts on the prices of stocks, commodities, currencies, indices,.... Those options need additional inputs/parameters such as the maturity of the contract and the price level where the contract can be exercised. But overall, insurance has a value only because there is uncertainty. And the more you feel risky and you are risk averse about that uncertainty, the higher will be the price you are ready to pay for your insurance contract. On the other hand, the award-winning Black-Scholes-Merton model that was used for option pricing since 1973, was assuming a constant volatility over the life of the contract. And all option traders, statisticians, econometricians knew that, depending on the time window, the measure was changing.

In the 80s, one of them, Robert Engle, appeared working on Autoregressive Conditional Heteroskedasticity models of the volatility, at some point also with Clive Granger in 1987 (Econometrica), and both won the Nobel Prize in Economics in 2003 (Engle and Granger lectures). This would give rise to the ARCH, GARCH, EGARCH, HGARCH, NGARCH, QGARCH, TGARCH....of this World in the years after. More recently, Robert Engle has been the instigator of V-Lab, an online platform producing regularly and automatically estimates for a wide range of time-series. Some nice resources are also available online with the FT.

Finally, a key differentiation must be made between "statistical, historical or realized volatility", whatever the methodology to assess, estimate and predict volatility could be, and "implied volatility". The CBOE has since then created the VIX, an index of implied volatilities from S&P options and others, assumed to represent the expected volatility over the next 30 days. Now, historical volatility and implied volatilities are very different in their approach and meaning. Since the implied volatility is a parameter that has been calibrated based on options of varying maturity and moneyness (the distance between the current price and the strike), it is a measure that depends not only on what the market perceives from the uncertainty on underlying's returns but also of how much the market wants insurance. Therefore the implied volatility is before everything else a measure of how expensive is the insurance today. In times of crisis, you might have a big discrepancy between the realized and the implied volatilities if the general market fear impacts a lot option prices but much less the current offer and demand of the underlying itself (see for example a blog on the matter).

But the true evidence that volatility remains a complex notions that should not be seen as static or independent of risk perceptions (in the case of the implied one), is that the implied volatility measure changes with the maturity and the moneyness of the option. This means that, when crossing both, we  obtain a surface of implied volatilities (see example picture from Bloomberg):

Now, philosophically, it seems a little bit peculiar to show up a volatility surface by "inverting" an option-pricing formula that...assumes a constant volatility. Thus the impetu of econometricians to come up with a model for the evolution of volatility...

A newly managed floating Kyat

Since April 2nd, the Kyat (Myanmar's currency) moved from 6.4335 MMK/USD to 818, in a decision to adapt the unrealistic former rate to a more market-based one. The intention forward is to let the Kyat float completely, with a current quasi-managed regime aiming to it. That will require Myanmar to start accumulating more foreign reserves and the country's Central Bank will be accepting foreigners to freely bring in international currencies in amounts up to 10K USD without any declaration and free international transfers will be soon on the way.

Myanmar's Kyat (MMK) evolution over the last month.The evolution between March 31st and April 2nd should show as a discontinuity in the rate of the currency.

As for all countries opening their economies to international markets under the pressure of others,

Research in Finance: Evolution and Perspectives

[in French]
Les Amis de la Bibliothèque de l'ULB ont le plaisir de vous inviter a leur prochaine rencontre. Les Midis des Amis de la Bibliothèque de l'ULB offrent l'occasion aux chercheurs et enseignants de faire connaître plus largement leurs publications. Ces rencontres ont lieu le mercredi de 12h15 à 14h et prennent place dans un espace approprié aux thèmes abordés. La prochaine séance aura lieu le 25 AVRIL 2012 dans l'auditoire R42.2.110 situé dans le bâtiment qui abrite la Solvay Brussels School of Economics & Management (SBS-EM), Avenue Roosevelt 42 - 1050 Bruxelles. 
« La recherche en Finance : Evolution et Perspectives », par André Farber et Kim Oosterlinck

Gekko is back

Michael Douglas received an Oscar for his role as Gordon Gekko in the 1987 film Wall Street. He remains famous for his line “greed is good”. Aficionados should rejoice: Gekko is back but in a new role as spokesman of the Federal Bureau of Investigation in its war against insider trading. His new line: “If a deal look too good to be true, it probably is”.

Insider trading refers to trades of securities by individuals based on non-public information. Such transactions are considered as unfair since one side of the trade has private information that has not yet affected the price of the security. Therefore, lawmakers consider that insider trading is bad for financial markets. Regulations to ban trading on inside information have been introduced in the US as early as 1934. Other countries implemented similar rules, although more recently (see Bhattacharya and Daouk 1992). This theme keeps lawmakers busy on both side of the Atlantic. In Europe, for instance, the European Commission is currently working on MAD II, the second incarnation of its Market Abuse Directive.

Academics are not sure that insider trading is all bad. Leland (2002) summarized the arguments as follow:

“Pro.-(a) Insider trading will bring new and useful information into asset prices. Decision makers-both portfolio managers and firms making real investment decisions-can reduce risk and improve performance when prices reflect better information. (b) Because of reduced risk, asset prices will be higher and more real investment will occur.

Con.-(a) Outside investor will invest less because the market is “unfair”. Asset prices will be lower and less real investment will occur. (b) Market liquidity will be reduced, thereby disadvantaging traders who must trade for life cycle or other reasons not related to information. (c) Insiders trading will make current stock prices more volatiles, further hurting traders with liquidity needs.”

Sorting through these arguments will take time and the outcome is uncertain. It should be based on empirical evidence. Measuring the benefits of insider trading requires calculating the difference between the “wrong price” and the “right price”. In a beautiful paper, Liza Meulbroeck (1992) analyses stock price effect of insider trading in the US. She finds that “the stock market detects the possibility of informed trading and impounds this information into the stock price.” Markets might be better than regulators to detect insider trading. More recent evidence is badly needed. Stephen Bainbridge, a law professor at UCLA, provides a legal viewpoint on his website ProfessorBainbridge.com.

Gordon Gekko might have been right in the first place.

References

 Scannell, K. (2012), FBI casts Wall Street’s Gekko to remind traders greed is no good, Financial Times, February 28 2012

Bhattacharya, U. and H. Daouk (2002), The World Price of Insider Trading, Journal of Finance 62, 1 (February) 75-108

Leland, H. (2002) Insider Trading: Should It be Prohibited?, Journal of Political Economy 100, 4, 859-887

Meulbroek, L. (1992) An Empirical Analysis of Illegal Insider Trading, Journal of Finance 47, 7 (December) 1661-1699

A short story

Some days ago, France and Spain lifted the restrictions they had imposed on short selling (Financial Times, February 13 and February 16, 2012).  Many countries had implemented similar bans in 2008 in reaction to the financial crisis. (see Beber and Pagano, Journal of Finance, forthcoming for more details).

Sovereign Debt Diplomacy

The recent second Greek bailout has been accepted after intense negotiations. As for any negotiations, countries came with their own political agenda. Press reports shed some light on these motivations. For example, European diplomats informed the Financial Times that “the German and Dutch finance ministers pushed for further “haircuts” in Greek bonds” suggesting that these countries were willing to limit the involvement of their taxpayers.

Although the role of diplomacy is important, the exact motivations of the countries providing the bailout are often overlooked. Diplomatic, economic and geopolitical considerations probably play a more important role than pure altruistic motivations. For instance, Der Spiegel published a few months ago an insightful article detailing French sales of military vessels to Greece, which was already at the time struggling to make end meets. The article stressed German reactions to these sales. Surprising as it may seem, it was not the sale itself which was questioned but the fact that ThyssenKrup had lost the deal to the French company DCNS! German taxpayer money was going to end up subsidizing a French company (read: instead of a German one). Critiques regarding arm sales to Greece had however been voiced a year earlier by Turkey. Stephen Castle, in the New York Times had indeed reported in March 2010 that “Egemen Bagis, Turkey’s chief negotiator with the European Union, has criticized Germany, along with France, for seeking to sell military equipment to Greece while pressing the government in Athens to make drastic public spending cuts as a result of its dire financial crisis.”

Greece, Germany and “Supersanctions”

“The German government wants Greece to cede sovereignty over tax and spending decisions to a eurozone “budget commissioner” to secure a second €130bn bail-out.”

“German holders of Greek bonds had demanded international financial control of Greek finances.”

Despite their strong similarity, 119 years separate these two quotes. The first one emanates from the January 27th, online version of the Financial Times, the second one is the description made by Wynne (1951) of the Greek situation in 1893!

Greece before Greece… Betting on Victory and Patriotism

Greek is under the spotlight…and, with my partner and in laws from Cephalonia, I could not resist sharing my thoughts about the earliest Greek default.

Following the fall of Constantinople and the end of the Byzantine Empire, Greece fell under the Ottoman rule. Many attempts to regain independence failed during the following centuries. At the beginning of the 1820s, the war between Persia and the Ottoman Empire opened a window of opportunity to start a revolution. As had been the case with Latin American countries seeking independence at the same time, the Greek insurgents badly needed external finance to wage the war.

The Hull nouveau has arrived

Some days ago, after my first Derivatives class, a student asked me whether he should buy the latest edition of John Hull’s “Options, Futures and Other Derivatives” (JH8).  He had borrowed the 1^st edition (JH1) from his father and was wondering whether the new version was very different. Browsing through the new edition, he quickly realized that this was the case.  My advice was: “Keep the 1^st edition as might gain value. Buy the new edition, use it for this class and transmit it to your children. The return on investment should be positive”.

Colloque sur les Agences de Notation (26 mars 2012, Brussels) Save the date!

Les agences de notation entre les marchés et les Etats 
Créées au début du siècle dernier pour informer les investisseurs sur la santé économique des entreprises de chemin de fer, les agences de notation financière défrayent la chronique. Mises en cause en 2008 pour leurs notations des produits structurés responsables de la « crise des subprimes », elles sont aujourd’hui critiquées en tous sens pour leur rôle dans la crise de la dette souveraine. Hier encore structures mystérieuses du monde de l’expertise, les agences de notation financières sont désormais au cœur des débats d’une opinion publique inquiète. Quelles méthodes de notation financière mettent-elles en œuvre et que faut-il en penser ? Comment ont-elles été propulsées au rang de régulateur mondial du crédit ? Quelles sont les règles juridiques qui encadrent ou devraient encadrer leurs actions ?  Ne sont-elles pas en train de faire main basse sur des enjeux politiques à l’égard desquels elles ne jouissent d’aucune légitimité ? Ne sont-elles pas également un symptôme d’une évolution plus fondamentale de la gouvernance globale ? Autant de questions que se posent tant les spécialistes de ces matières que les citoyens.
Afin de contribuer à ces débats, le Centre Emile Bernheim de la Solvay Brussels School of Economics and Management (ULB) et le Centre Perelman de Philosophie du droit de la Faculté de Droit (ULB), au sein du Finance Club of Brussels, organisent conjointement une journée d’étude le lundi 26 mars 2012. Réunissant des spécialistes issus du monde de la finance, du droit et de la philosophie, celle-ci a l’ambition de confronter les points de vue sur les agences de notation et leur rôle dans une perspective interdisciplinaire.