Friday, July 10, 2009

Implied volatility update


At the risk of oversimplifying a very complex subject, the implied volatility of an option contract can be thought of as a measure of how much people are willing to pay to reduce their risk exposure—in other words, a measure of fear. This chart compares the implied volatility in equity and Treasury bond options. Both measures of fear have declined significantly from their highs of last year, but they are still high from an historical perspective. We're not out of the woods yet, but we're making progress.

4 comments:

M Miller said...

Scott,

Sometime, would you mind reading and commenting on this piece. It's the core of the issue for me. It's a focus on the debt problems. They don't focus on debt service, just debt level, but still, doesn't there need to be at least a 50% weight or so given to the potential of the Japan problem in the U.S., although our demographics and policies are somewhat different. How would you address this piece with a client for which you manage millions of dollars. Is this a trading environment, ie.. be flexible and adjust week to week and month to month because of the uncertainty. Just curious, if you have the time. Thanks for all your insight.

http://www.caldwellorkin.com/PDF/Update_0709.pdf

Scott Grannis said...

I have two problems with this piece. One, the authors take a Keynesian approach to the economy; they assume that consumer spending (demand) is what makes the world go 'round. I'm a supply-sider because I believe that demand is NOT the driver of the economy. I believe that work, investment, and risk-taking (supply) are what drives the economy. Whether consumers spend more or less is not important. What matters is whether people are working harder and more efficiently or not. Supply creates its own demand, as he great F. Say said.

Supply-side indicators tell me that things are picking up. Demand will follow.

Second, they put too much emphasis on debt. Debt does not make the world go 'round either. It merely redistributes the fruits of labor. One person's savings is another person's spendable cash. If we leave aside money created by the Fed (which hasn't expanded more than usual so far), borrowing does not create either new money or new demand.

Consumers are deleveraging and probably will continue to do so, but that does not condemn the economy to weakness.

M Miller said...

Thanks Scott. There is alot to chew on in your response. I have several Austrian econ friends that believe its all about the debt, and that is their central focus. Their entire world view is framed through debt to gdp, and they foresee collapse of the entire system. I would note that the late John Templeton felt we would not collapse under actual and projected debt, notably benefits plans like Soc. Security and Medicare, because he said every country will simply delay the retirement age by ten years. Done, solved. Keep up the great work. Although "retired", your value to many including me is extremely high, even though we're just talking money. But money helps take care of family and friends, and others in need. Best.

Scott Grannis said...

I think the Austrians pay way too much attention to debt. What they should instead focus on is monetary policy. When monetary policy is inflationary, people are encouraged to short the currency because inflation implies the loss of value of the currency. There are many ways of shorting the dollar: sell dollars and buy euros; sell dollars and buy land; sell dollars and buy gold; borrow dollars and do any of those things. So you find that the prices of gold, other currencies and real estate rise in an inflationary world. At the same time, people are building homes and office buildings, because those are the things that can retain their value while providing services. Eventually people wind up borrowing too much and buying too much and building too much. The Austrians call that "malinvestment." But it is simply the inevitable consequence of inflationary monetary policy. Debt doesn't kill you, but you get killed when you borrow a lot and real estate prices start falling; when the world ends up not being what you were betting on.

The solution is to just reprice everything and then continue. Of course, a toll is extracted, and living standards fall, but life goes on.