The Low Volatility Puzzle: Are Investors Complacent?

from Liberty Street Economics

-- this post authored by David Lucca, Daniel Roberts, and Peter Van Tassel

In recent months, some analysts and policymakers have raised concerns about the unusually low level of stock market volatility. For example, in the June Federal Open Market Committee (FOMC) minutes “a few participants expressed concern that subdued market volatility, coupled with a low equity premium, could lead to a buildup of risks to financial stability."

In this post, we review this concern and find the evidence of investor complacency is mixed. On one hand, we present a view suggesting that historical volatility may have been abnormally high, rather than current volatility being abnormally low. On the other hand, we find that estimates of the volatility risk premium are somewhat low, which is consistent with the view that investor risk tolerance has increased. We extend this analysis in a related post publishing on Wednesday.

The Low Volatility Puzzle

However you measure it, stock market volatility is unusually low. As of September 21, the year-to-date standard deviation of S&P 500 daily returns has been 0.45 percent, the lowest level since 1965 on an annual basis. Intraday volatility is also low. As the chart below indicates, estimates of realized volatility are currently around 6 percent in annualized units, near the minimum of the historical distribution. The chart also reports the Chicago Board Options Exchange Volatility Index (VIX), a market-based measure of implied volatility over a one-month horizon from forward-looking S&P 500 index option prices. Despite a backdrop with high political uncertainty (for example, as measured by Baker, Bloom, and Davis’s economic policy uncertainty index), the VIX is currently around 9-10 percent after hovering near all-time lows for much of 2017.

The Low Volatility Puzzle: Are Investors Complacent?

Common View: Today Is Abnormal and Current Stock Market Volatility Is a Concern

Aside from the FOMC minutes excerpt above, other commentators (for example, see Jeffrey Frankel’s recent blog post) have raised concerns about the low level of stock market volatility, especially given the low level of interest rates, which many associate with investors’ increased willingness to take on risk (or reach for yield). Based on similarities to the low volatility environment before the financial crisis, some suggest that investor complacency may contribute to a major correction in equity markets when volatility returns to a “normal" level.

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Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors ...

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