Heightened Volatility to Hinder U.S. Economy as Credit Market Problems Persist

Heightened Volatility to Hinder U.S. Economy as Credit Market Problems Persist

Amidst the explosive growth in structural innovations such as collateralized debt obligations in financial markets in recent years, volatility has reemerged as a major concern. We believe volatility will remain above its long-term average over the next year and potentially will have substantial adverse effect on the U.S. economy.

The Chicago Board Options Exchange Volatility Index (VIX) reached a four-year high in August amid the turmoil in subprime mortgage and commercial paper markets. Concerns with the state of the U.S. housing and corporate credit markets and structured investment vehicles have led to doubts about the global economic outlook. The housing sector remains weak with most forward-looking indicators of U.S. housing demand pointing to a further deterioration in sales in the short-term. High-yield corporate bond spreads have surged since June to near their highest levels in four years as the chaos from the subprime mortgage market spread. The days of companies having easy access to the credit markets no longer exist.

This rise in economic uncertainty has led to higher market volatility since the VIX reached a five-year low in January. In this paper, we employ quantitative techniques to explain the causes of the rise in systematic risks observed in the market. Investment risks can be divided into systematic and unsystematic risks. Systematic risks refer to non-diversifiable risk factors that are compensated by an expected risk premium. Unsystematic risks, which are investment specific, are idiosyncratic and can be minimized through diversification. While unsystematic risks are known to mainly reflect microeconomic shocks affecting assets’ relative prices, systematic risks are recognized to mainly reflect macroeconomic shocks. We employ a framework that decomposes observed levels of market volatility or systematic risk into key economic and financial variables. Systematic risks, the implicit market price of risk, merely become a function of the selected fundamental explanatory variables introduced in the model.


The Relationship between the Standard & Poor’s 500 Implied Volatility Index (VIX) and Significant Economic Variables.

We analyzed the relationship between a range of financial and economic variables and the S&P 500 implied volatility index. Theory and empirical evidence suggest that the weekly log-differences of the implied volatility index can be explained in the order of importance by the following variables: equities as shown by the S&P 500 Index, volatility, changes in the yield curve, movements in the volume of open interest, oil prices and the U.S. Dollar Index.

Based on our analysis, these variables consistently influence the implied volatility index with negative S&P 500 returns having the most impact.

We observed a positive relationship between the historical and implied volatility indices (clustering effect), and a negative relationship between the implied volatility index and the underlying stock returns. This second phenomenon is asymmetric in nature -- negative index returns have a greater impact on implied volatility as an increase in the equity of the firm decreases the companies’ debt-to-equity ratio (leverage effect) and therefore risks.

The effect of changes in the yield curve level and slope are unclear -- an increase in interest rates decreases both the value of debt and equity. The impact of increasing interest rates on firms’ debt-to-equity ratio and therefore on volatility is as a result ambiguous. In addition, the effects of higher short-term interest rates over the period were typically offset by a flattening or inversion of the yield curve.

We also observed that currency appreciation has led to decreases in systematic risks in that currency’s economy. While an increase in oil prices raises economy uncertainty and therefore is expected to increase systematic risks. Finally, the volume of contracts traded in the underlying index is expected to be positively correlated with systematic risks.

Based on our volatility model, all significant factors can be considered when inferring the evolution of future short-term volatility levels.
Significant swings in stock indices should sustain higher levels of systematic risks
Higher levels of historical volatility should cause comparatively increased levels of systematic risks (clustering effect)
The effect of lower short-term interest rates should in part be offset by a steeper slope of the yield curve
Continued depreciation of the U.S. dollar and higher crude oil and commodity prices should also contribute to higher systematic risks

In conclusion, a large portion of the variance of the VIX is caused by identifiable factors. The tightening in corporate credit and continued weakness in the housing market have created economic uncertainties. In addition, the combination of the U.S. dollar falling against the currencies of its trading partners and crude oil trading near record levels boosts our expectations for volatility to remain above its long-term average over the next year.