In a previous post, we pointed out several reasons why the VIX is so low
There are several explanations. But in our opinion, currently nobody
knows the exact reasons yet. However, a consensus started emerging.
Several market experts say that volatility is low because of the
increase in the short volatility trade through VIX-based ETFs. Dani
Burger reported:
While gallons of ink have been spilled on whether the VIX is
“broken,” some traders are now suggesting that exchange-traded products
linked to the index have a hand in the perceived distortion. What’s
more, they warn, their popularity — VIX ETPs have absorbed $700 million
this year — could exacerbate a selloff if volatility spikes.
Yet budding evidence suggests that VIX ETPs — a more than $3
billion industry that includes the popular $1 billion iPath S&P 500
VIX Short-Term Futures ETN, symbol VXX — have altered the futures
market, and at times indirectly influenced the index itself.
However, there are people who don’t agree
Most strategists believe there are stronger forces than ETPs
keeping the VIX low. An accommodative Federal Reserve and European
Central Bank, strong earnings, low sector correlation and numerous other
positive market indicators have capped pessimism, they say.
It’s difficult to prove that ETPs apply constant pressure that
pushes the VIX lower, according to Ramon Verastegui, head of flow
strategy and solutions in the Americas at Societe Generale SA. Still,
with ETPs looming as such a large market presence, they affect the VIX’s
term structure while the threat of a sell-off hangs over the index.
When VIX futures move 1 point, typically the VIX spot price moves 1 to 2
points, Verastegui said. Read more
Regardless of the reasons, the short volatility trade seems to be
crowded. Therefore, it can have a huge impact on the market in case of
panic and everyone wants to exit. Dean Curnutt wrote
The hurricane is not more or less likely to hit because more
hurricane insurance has been written. In the financial markets this is
not true. The more people write financial insurance, the more likely it
is that a disaster will happen, because the people who know you have
sold the insurance can make it happen. So you have to monitor what other
people are doing.
While Haghani’s statements were focused on the manner in which
LTCM-specific trades were seemingly attacked by the market, they remain
highly relevant today because the notion that financial market insurance
is not like hurricane insurance is broadly applicable. When trades are
especially crowded, their unwinding can amplify market moves as
investors seek to de-risk in unison. Stable markets not only invite
trades that bet on the continuation of stability, they almost force
investors to pursue them in an investment climate so deprived of nominal
return. Read more
The title of this post, Financial Market Insurance is Not Hurricane Insurance refers
to Haghani’s statement above, i.e. unlike the insurance markets, in
financial markets everyone can sell insurance, and this can lead to a
crowded trade.
Interestingly, from a mathematical point of view, pricing an
insurance contract is vastly different from pricing an option contract.
The former is priced in the statistical measure, where the latter is
valued in the risk-neutral world. But this will be the subject of
another post.
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