Despite last year’s significant market surprises and macro risks, namely the U.S. election of Donald Trump and Brexit, we have seen an overall decline in implied volatilities.
As implied volatilities have declined, we believe this may be a confirmation that investors’ risk appetite is coming back after the significant risk oppression that took hold and has persisted following the 2008 global financial crisis.
The return of risk appetites could signal the end of an era of insatiable demand for safe assets that has characterized markets since the 2008 crisis.
To measure risk appetite, we build a proprietary index in which we compare the implied volatility of equity markets and bond markets to our forward-looking estimate of volatility as measured by our equilibrium risk model. When the index is at 100%, global implied volatilities are at fair (or fundamental, in our team’s parlance) value. When the index is above 100%, implied volatilities across the world are greater than fair value, and when the index is below 100%, it is an indication that implied volatilities are lower than our forward-looking expectations.
What’s interesting is the evolution of implied volatilities that we have witnessed recently. If you look at 2016, the early part of the year had a very high level of volatility given that we were in the midst of the commodity and emerging market selloff. Our proprietary index was at about 150% at that time.
So, we started at high levels of volatilities and then in the second quarter of 2016, implied volatilities in the United States and in Europe fell below the long-term equilibrium level. As we approached the U.K. (Brexit) referendum, implied volatilities spiked again, rising to approximately 30% above equilibrium. Despite the Brexit “surprise,” implied volatilities very quickly fell to about 20% below equilibrium in late July/early August. Subsequently, implied volatilities rose again heading into the U.S. election, but this time they only rose to the equilibrium level.
Despite the peaks and valleys of implied volatilities, the prevailing trend was certainly lower. And that was in an environment full of surprises and significant political and macro risks. As of April 2017, implied volatilities are low across bond and equity markets (our index is currently roughly 25% below equilibrium), while geopolitical uncertainty remains elevated with upcoming French presidential elections where Marine Le Pen could pose a serious challenge to the European Union if elected.
The picture is not completely uniform as the decline in volatility is especially prevalent among short-term at-the-money options, but overall it suggests that risk appetites are returning despite a geopolitical environment that remains uncertain. This could signal the end of an era of insatiable demand for safe assets that has characterized markets since the 2008 crisis.