Date posted: October 19, 2008

This Is Called Volatility Clustering

I had wanted to post this last week, but I didn't have the time, because I had to finish a presentation for a symposium. Anyway, it's still relevant.

Last Monday everybody cheered because share prices saw their largest one-day gains in decades. This was after the dramatic drops of the week before, which, added together, amounted to a crash. It was also before the drops of three days later when the fear that there may be a global recession began to settle in.

There's nothing unusual about the large swings in share prices of the past few weeks. Indeed years ago, in 1992, I wrote my MSc thesis in econometrics on heteroskedasticity in financial timeseries. This is the technical term for volatility clustering. It's still relevant to this day. In 2003 Robert Engle was awarded the Nobel prize in economics for developing methods to model time-series with time-varying volatility. His Nobel lecture is an excellent introduction to the use of so-called GARCH models in finance. This is also what my thesis was about.

The current market conditions also remind me of a paper from 1999 by Emanuel Derman on regimes of volatility. Around that time large up and down swings of a few percent seemed normal. The past few years were characterized by relatively low volatility. Right now implied volatilities across the board are extremely high.

There's even more. Volatility appears to be higher in the early morning and late afternoon. I agree with the author of this blogpost that traders are trying to reduce their positions so as to decrease overnight risk because nobody knows what might happens elsewhere in the world when local markets are closed.

It's not just equity markets where (implied) volatilities are going through the roof. The same is happening in FX and commodity markets. This is or will soon cause real problems, both for exporters for whom hedging their currency exposure is becoming increasingly expensive and for banks whose VaR numbers should by now be getting pretty large. The volatility in FX markets is most likely largely due to the unwinding of carry trades.

The classic cartoon to illustrate this is the one reproduced here by Kevin Kallaugher, better known as KAL, which first appeared on the cover of The Economist in 1989.

Incidentilly, some weeks ago I wondered whether the then levels of the S&P 500 and other indices reflected the current economic conditions, as they were at their 2006 levels. They do now, but in analyst's speak it is still too early to call the bottom and there is still some room for downward potential as the markets get to terms with the prospect of a prolonged economic downturn.