Financial Market Insurance is Not Hurricane Insurance

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.