# Era of Calm Ends as Volatility Returns to Markets

With the return of volatility in stocks, those investors and trades that profit when markets are calm are suffering heavy losses.
The above referenced WSJ article (published yesterday) tells a very interesting story about volatility as an asset class. VIX exchange-traded products (such as Credit Suisse’s now infamous and soon-to-become-defunct) VelocityShares Daily Inverse VIX Short-Term exchange-traded note (XIV)) were originally conceived of in the aftermath of the global financial crisis as a form of insurance against against increases in market volatility.
As we have previously discussed (see “On the relationship between the S&P 500 and the CBOE Volatility Index (VIX)“), returns on the S&P 500 stock market index and VIX tend to be strongly negatively correlated with each other.  Thus, VIX exchange-traded products such as XIV offer investors the opportunity to hedge against increases in volatility.  Indeed, by reversing the letters in the VIX ticker symbol, the VelocityShares Daily Inverse VIX Short-Term exchange-traded note in particular effectively branded itself as a financial product which hedges volatility.  However, as market volatility subsided during recent months and years, many investors began to sell rather than buy products such as XIV in hopes of boosting portfolio returns.  With stocks trading at historically low volatility levels lately, this strategy seemed to be working pretty well for many investors; that is, until this past week when volatility made its comeback:
The next graph shows the time series for daily closing prices on XIV and on VIX, from 11/30/2010 (which is the first day for which daily data for XIV are available) through yesterday (2/6/2018):
Within this date range, the correlation between XIV and VIX is -.5608.  Of course, the most interesting aspect of this graph corresponds to the enormous drop in XIV from its all-time closing high of 144.75 (on January 12, 2018) to 7.35 at the close yesterday.  On the same day that XIV reached its all-time closing high,  VIX closed at 10.16, but stood at 37.32 at the close on Monday, February 5.

# A Random Walk Down Wall Street

In my opinion, if you were to read only one book about finance, it would have to be “A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing” by Burton G. Malkiel. Malkiel’s book (now in its 11th edition) provides a compelling argument in favor of efficient markets theory and investing in (passively managed) index funds.

Efficient market theory implies that stock prices follow a random walk. These ideas were originally conceived of by Professors Paul Samuelson and Eugene Fama in the 1960’s, and subsequently popularized by folks like Professor Malkiel. In Finance 4366, we rely extensively upon the notion that prices of speculative assets (e.g., stocks, bonds, commodities, foreign exchange, etc.) follow random walks as we consider the technical details associated with pricing and hedging risk using financial derivatives.

# The Index Fund featured as one of “50 Things That Made the Modern Economy”

Tim Harford also features the index fund in his “Fifty Things That Made the Modern Economy” radio and podcast series. This 9 minute long podcast lays out the history of the development of the index fund in particular and the evolution of so-called of passive portfolio strategies in general. Much of the content of this podcast is sourced from Vanguard founder Jack Bogle’s September 2011 WSJ article entitled “How the Index Fund Was Born” (available at https://www.wsj.com/articles/SB10001424053111904583204576544681577401622). Here’s the description of this podcast:

“Warren Buffett is the world’s most successful investor. In a letter he wrote to his wife, advising her how to invest after he dies, he offers some clear advice: put almost everything into “a very low-cost S&P 500 index fund”. Index funds passively track the market as a whole by buying a little of everything, rather than trying to beat the market with clever stock picks – the kind of clever stock picks that Warren Buffett himself has been making for more than half a century. Index funds now seem completely natural. But as recently as 1976 they didn’t exist.  And, as Tim Harford explains, they have become very important indeed – and not only to Mrs Buffett.”

Warren Buffett is one of the world’s great investors. His advice? Invest in an index fund

# Insurance featured as one of “50 Things That Made the Modern Economy”

From November 2016 through October 2017, Financial Times writer Tim Harford presented an economic history documentary radio and podcast series called 50 Things That Made the Modern Economy. This same information is available in book under the title “Fifty Inventions That Shaped the Modern Economy“. While I recommend listening to the entire series of podcasts (as well as reading the book), I would like to call your attention to Mr. Harford’s episode on the topic of insurance, which I link below. This 9-minute long podcast lays out the history of the development of the various institutions which exist today for the sharing and trading of risk, including markets for financial derivatives as well as for insurance.

“Legally and culturally, there’s a clear distinction between gambling and insurance. Economically, the difference is not so easy to see. Both the gambler and the insurer agree that money will change hands depending on what transpires in some unknowable future. Today the biggest insurance market of all – financial derivatives – blurs the line between insuring and gambling more than ever. Tim Harford tells the story of insurance; an idea as old as gambling but one which is fundamental to the way the modern economy works.”

# Stocks Weren’t Made for Social Climbing

Superb WSJ op-ed by (former hedge fund manager turned author) Andy Kessler about the corporate social responsibility “gospel” and the importance of profit; Kessler’s essay is essentially an homage to Milton Friedman’s famous 1970 New York Times Magazine article entitled “The Social Responsibility of Business Is to Increase Its Profits.”

Profits are the proper gauge of a company’s value to consumers—and to society.

# The rise and fall of Bitcoin

Excellent insights (and context from economic history) from The Economist about the rise and fall of Bitcoin!

Investors in Bitcoin are learning some very old lessons

# Graph of the day: Daily volatility of Bitcoin (BTC) vis-à-vis other asset classes

Graph of the day – daily volatility of Bitcoin (BTC) vis-à-vis other asset classes (WTI (oil), silver, gold, US stocks (SP500), Euro/Dollar exchange rate, 10 year T-bond, 1 year T-bill, and 1 month T-bill). Source: WSJ Daily Shot, 11-January-2018.

# Fewer Listed Companies: Is That Good or Bad for Stock Markets?

Today’s WSJ provides an interesting historical perspective of the cumulative effects of the dot-com bust, implementation of Sarbanes-Oxley, M&A activity, share buybacks, and growth of private equity on the number of listed shares in US stock markets during the course of the past couple of decades. Also see http://derivatives.garven.com/?p=6639 for an academic perspective of the so-called “U.S. listing gap”, which is apparently due to a decrease in new listings coupled with an increase in delistings over this period.
As the Dow Jones Industrial Average broke through 25000 and other stock market indexes continue rising to new highs, the number of publicly traded U.S. companies keeps shrinking.

# Volatility is Dead Everywhere

The Wall Street Journal recently published an important article (linked below) which documents the (unprecedented) synchronized compression of implied volatility across multiple asset classes; specifically, US equities, oil, gold, and US interest rates.

# On the relationship between the S&P 500 and the CBOE Volatility Index (VIX)

Besides going over the syllabus during the first day of class on Tuesday, January 9, we will also discuss a “real world” example of financial risk. Specifically, we will look at the relationship between short-term stock market volatility (as indicated by the CBOE Volatility Index (VIX)) and returns (as indicated by the SP500 stock market index).

As indicated by this graph from page 24 of next Tuesday’s lecture note, daily percentage changes on closing prices for VIX and the SP500 are strongly negatively correlated. In the graph above, the y-axis variable is the daily return on the SP500, whereas the x-axis variable is the daily return on the VIX. The blue points represent 7,056 daily observations on these two variables, spanning the time period from January 2, 1990 through December 29, 2017. When we fit a regression line through this scatter diagram, we obtain the following equation:

${R_{SP500}} = 0.00058 - 0.1187{R_{VIX}}$,

where ${R_{SP500}}$ corresponds to the daily return on the SP500 index and ${R_{VIX}}$ corresponds to the daily return on the VIX index. The slope of this line (-0.1187) indicates that on average, daily VIX returns during this time period were inversely related to the daily return on the SP500; i.e., when volatility as measured by VIX went down (up), then the stock market return as indicated by SP500 typically went up (down). Nearly half of the variation in the stock market return during this time period (specifically, 49.2%) can be statistically “explained” by changes in volatility, and the correlation between ${R_{SP500}}$ and ${R_{VIX}}$ comes out to -0.7014. While a correlation of -0.7014 does not imply that ${R_{SP500}}$ and ${R_{VIX}}$ will always move in opposite directions, it does indicate that this will be the case more often than not. Indeed, closing daily returns on ${R_{SP500}}$ and ${R_{VIX}}$ during this period moved inversely 78% of the time.

You can see how the relationship between the SP500 and VIX evolves prospectively by entering http://finance.yahoo.com/quotes/^GSPC,^VIX into your web browser’s address field.