We’ve pondered before why volatility is currently so low .
One theory we presented was the rise of new strategies to fund tail-risk protection, focused on long-dated far out of the money options, funded by options sales nearer the front.
But here are some more thoughts on the matter as it pertains to the rate market, this time from Bank of America Merrill Lynch’s Liquid Insight report on Thursday.
Our emphasis:
While fiscal issues are a long-term concern for the US rates market in the form of increased issuance in the future, in the near term it is possible that the market could start worrying about lower growth.
We believe it is worthwhile to consider buying some protection for lower yields. In this context, it helps that implied volatilities have continued to decline as realized volatility in the recent past has been low.
One additional reason for low implied volatilities is the sale of gamma as an alpha strategy by investors. As dealers get long gamma and delta hedge their positions, realized volatility becomes low. In addition to low levels of volatility, the steepness of the yield curve means that carry and rolldown on long receiver positions is still quite attractive. This combination of a steep yield curve and low implied volatility levels has made it an opportune time to buy downside protection in rates.
In other words, a lot of people are selling gamma to generate alpha. In English that could be understood as unprecedented levels of volatility selling — via many different options strategies — possibly on the notion that the Bernanke put will keep volatility contained.
The strategy depends specifically on collecting premiums, rather than anything connected to underlying moves in stocks or indices. A bit like picking up pennies in front of the proverbial steamroller.
But obviously to work, it also needs a dedicated base of non fussy buyers of volatility — or those prepared to fund the gamma sellers’ premium based strategies.
Those hedging Vix products are plausible suspects. Indiscriminate flows and buying from such funds may in fact be facilitating the gamma selling strategy — something which may be pushing volatility lower, while encouraging further delta hedging in Vix futures, which consequently is steepening the general Vix curve as well as the S&P 500 at-the-money term structure.
But the real point is that almost everyone appears to be short spot volatility, and potentially delta hedging via longer dated tools.
Which could mean that the wider market has decided to cash in on the Bernanke put too, writing options of its own while it can.
The implications of all this are notable. As Artemis Capital Management, a volatility-focused investment management firm, recently wrote in an excellent note which asked whether volatility could be broken:
The artificially low volatility in markets may contribute to a dangerous build up in systemic risk. Many investment banks and hedge fundsuse volatility as an input to determine leverage capacity. When the Fed artificially depresses spot volatility it produces a feedback loop whereby large banks can increase their appetite for risk, increasing assets prices, and further lowering volatility. It should be no surprise that NYSE margin debt is at its highest level since July of 2008
The paper’s author Christopher Cole further agrees that things like steep volatility term structures are not normal and refer to the bizarre break-out of variance — the volatility of volatility — as used in portfolio insurance.
Indeed, while realised volatility, implied ATM volatility and the VIX are all low, the cost of variance swaps and volatility options remain at elevated levels versus norms, something which is now starting to compromise returns on volatility insurance policies.
Artemis, luckily, has some clear thoughts about what’s causing all of this, some of which echo our own observations above.
1) Changes in the supply/demand dynamics of volatility:
Recent structural changes in the supply demand dynamics of volatility may be contributing to the distortions reflected in today’s vol surface.
First, a liquidity shortage on the long-end of the OTC volatility surface emerged as sophisticated players covered short positions following substantial losses on volatility derivatives in May (less supply).
2) A preference for longer-dated volatility hedging is emerging and also changing the demand picture:
Secondly, there has been a recent proliferation of new “tail risk” or “black swan” hedging strategies that have increased the demand for long-dated volatility and far out-of-the-money options (more demand).
3) Gamma selling is rife:
Thirdly , as margin debt has expanded many funds are now shorting spot volatility and buying long-vol to collect pennies from underneath the proverbial steamroller (short-term supply, long-term demand).
Which makes us wonder if variance swaps are now a better indicator of market fear than spot Vix.
Related links:
Vix wagging – FT Alphaville
Bernanke’s genie released – FT Alphaville
Why is the Vix so low? – FT Alphaville
Volatility as the new Black-Scholes – FT Alphaville