Volatility in financial markets came sharply into focus in 2018 as the first signs of an ageing equity bull market showed themselves in the first quarter of the year. After a period of relative calm and recovery the fourth quarter continued the theme of the first with some terrific downside moves.
But it’s not just the equity asset class that was subjected to wild swings and thus heightened volatility. Everything from currencies to commodities to fixed income displayed the same volatile characteristics.
Was 2018 a once off, or is volatility the ‘new normal’?
David Gracey, head of Fixed Income and Currencies at Investec thinks it is. “Volatility is part of our world, with regular bouts of extreme volatility becoming more and more regular”.
His colleague in Fixed Income, Denvin Naidoo, concurs. “It’s more and more a part of our daily lives, and when volatility occurs it affects liquidity and therefore our market making abilities”.
Listen to podcast: finding opportunity in volatility
A double-edged sword
Typically a fixed income and currency desk at a major institution like Investec will be multi-functionality organism. Apart from market making and hedging clients’ risk exposure, there might also be proprietary trading activities that look for the risk that others are seeking to avoid. Volatility can thus be a double-edged sword.
The difference between implied and historic volatility is also an important factor. Historic volatility is an actual, quantifiable measure whereas implied volatility is a measure of volatility that an options trader, for example, will introduce to a pricing model and will habitually be higher than historic in order to hedge against extreme events.
Simply put, if a market is volatile, option prices become more expensive.
Are algos driving volatility?
But apart from extraneous events that cause volatility, does the financial services industry itself contribute to heightened volatile activity?
“Algorithmic trading programmes (algos) have been the cause of dramatic price movements, so yes they are a factor”, says Gracey. "But at the same time, they often provide people like us with increased liquidity, essential to our activities.”
How to manage volatility
It appears then that volatility is here to stay, which means the management of volatility is a skill that is at a premium.
“We have to be very aware of different potential risks, and spend a lot of time forecasting potential scenarios for our clients,” explains Naidoo.
Gracey expands on that theme: “We’ve been talking to Eskom for 18 months and in our opinion, the market was underpricing the risks associated with its balance sheet. The volatility in the Rand we’re seeing now is a result, and we factored that into our models.”
If volatility is here to stay, do South African companies, state-owned enterprises and even individuals manage it responsibly?
“It’s human nature to underprice potential risk going forward.”
“We deal with a lot of institutional clients, and they are very aware of it and build their own in-house models to deal with it” explains Naidoo.
Gracey, however, sounds a note of caution. “The advent of optionality has really helped institutions and corporates, but treasury departments need to be aware of them and smooth risks over time. Sometimes they’re not, perhaps because of the fear factor.”
Naidoo agrees: “It’s human nature to underprice potential risk going forward”.
So volatility is now a normal part of our lives, whether it be from a mismanaged balance sheet, a computer-generated trading system or a careless word from a rogue politician. Happily, the tools are at our disposal to thwart it.
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