Volatility-Contingent Strategies and Their Implications for Market Stability

The Bengaluru Chapter of CFA Society India hosted Professor Larry Harris, CFA for a session on the “Volatility-Contingent Strategies and Their Implications for Market Stability”. Professor Harris holds the Fred V. Keenan Chair in Finance at the USC Marshall School of Business and has served as SEC Chief Economist from 2002-2004. Further, the session was moderated by Dr. S G Badrinath, the Canara Bank Chair in Banking and Finance and Chair of the Centre for Capital Markets and Risk Management at IIM Bangalore. It was a remarkable learning opportunity for the Members and Candidates in Bengaluru.

Prof. Harris started the session by introducing the concept of Volatility budget and discussed several Volatility contingent strategies. After the crisis until recently, the volatility has dropped, and the asset prices have been rising. Implied volatility has been higher than the realised volatility.

This is the time when Investors scale up the portfolio volatility based on their volatility expectations. In the process, market participants take aggressive positions for scaling up the portfolio volatility and seek higher return prospects. Different market players use different strategies. Selling straddles, strangles, VIX products and rolling down the VIX future are some of the most cited ones.

Increasing the portfolio volatility to the target volatility levels for maintaining the carry, increases the gamma of the portfolio. Higher levels of gamma amplify the impact of corrections and the triggers big crashes.

He further added that markets do not fall when there are more sellers but when there are impatient sellers. Temptations are high when the yields are low. This is also the time when volatility usually rises and leads to market falls.

Finally, the audience took the note that we are in a world where a low-yield, low-volatility environment has drawn various market participants into essentially similar short volatility-contingent strategies with a common nonlinear risk factor. The impact of the extraordinary growth in the bets on volatility and bets modulated by volatility since the Global Financial Crisis is yet to be seen in full.

-VA