Implied volatility is driven by realized volatility, especially in short-dated options.
Volatility skew reflects a premium in downside puts, recognizing the market's tendency to crash down.
Deep dives
Implied Volatility and Realized Volatility
Implied volatility is driven by realized volatility, especially in short-dated options. The VIX is highly correlated with one-month realized volatility. The volatility risk premium (VRP) shows that implied volatility tends to exceed realized volatility, creating opportunities for carry strategies. Downside volatility tends to exceed upside volatility, with down moves mattering more in establishing realized volatility for equity indices. The volatility skew reflects a premium in downside puts, recognizing the market's tendency to crash down.
Volatility Across Asset Classes
Different asset classes have their own volatility measures. The debt ceiling crisis affects US sovereign CDS, with a substantial widening of spreads. Gold's relationship with the S&P during the 2011 debt ceiling crisis suggests it can act as a hedge during risk-off periods. The volatility term structure indicates that long-dated options have higher implied volatility than shorter-dated options. Volatility exhibits memory, with low volatility reinforcing stability and high volatility leading to de-risking episodes. Volatility regimes change based on monetary, regulatory, and fiscal policies, impacting the market's outlook. The reflexive nature of volatility suggests that prolonged periods of low risk premia can lead to a buildup of leverage and instability. Volatility events occur when consensus views are shattered.
Ten Handy Facts on Volatility
The podcast shares ten handy facts on volatility: 1) implied volatility is driven by realized volatility, especially in short-dated options; 2) implied volatility generally exceeds realized volatility, creating opportunities for carry strategies; 3) downside volatility tends to exceed upside volatility for equity indices; 4) volatility skew reflects a premium in downside puts; 5) volatility has a term structure, with longer-dated options having higher implied volatility; 6) volatility exhibits memory, with low volatility reinforcing stability and high volatility leading to de-risking episodes; 7) volatility mean reverts, with market disruption events ultimately leading to lower volatility; 8) volatility regimes change based on various factors; 9) volatility is reflexive, with prolonged periods of low risk premia leading to increased vulnerability; 10) volatility events occur when consensus views are shattered.
Welcome to a special edition of the Alpha Exchange, one in which your host and guest are one and the same. Above all, our conversations on this podcast are aimed at helping you think about risk. After all, it was the Spanish philosopher George Santayana who famously said, “those who forget history are doomed to repeat it.”
This podcast has three parts. First, an update on a project I’ve been working on, MacroMinds. I created this foundation back in 2019 to raise funding for causes in the NY area focused on student education. Our “business model” is simple – host a once a year, highly differentiated symposium featuring industry leaders who share their insights on the remarkably complex world of investing. On June 7th in NYC, we are doing just that, and I could not be more excited about our incredible agenda.
Second, I review a couple of prices in the world of optionality and what they mean in the context of today’s risk dynamics. Specifically, I discuss the fast widening level of CDS written on the US as the reference asset. In the context of the unfolding debt ceiling drama, this instrument is worth keeping an eye on. Next, I review the change in the volatility surface on gold, specifically the emerging bid to upside calls.
Lastly, I review some work I did a number of years ago, which I call, simply, “Ten Handy Facts on Vol”. These are characteristics of the behavior of volatility in asset prices and the options that are written on them. I hope you find some value in this exercise and I thank you for listening.
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