Sky High VIX, Driven by a Lack of Leverage?

[thrunner 10]

The VIX opened at a record 89 this AM with the US stock indices limit down. Everybody calls the VIX the 'fear index' as if the market is getting fearful. It is more likely that volatility is being artificially manipulated by the hedge funds and investment banks due to the recent credit deleveraging. In the absence of high leverage, one way to make as much money is to create chaos, fear and volatility in the markets - generating 'fear' but also similar income as a less leveraged position.

 

What do you think? Is there an inverse relationship between leverage (IBs margins at previously 30:1 before deleveraging, now down to perhaps less than 10:1) and volatility? Some would argue that the high volatility results in deleveraging or the lack of margins, but could it be the other way around for the larger players?

 

Looking for them to break the VIX before this is over; they have pretty much broken every other indexes.

 

Edited October 24, 2008 by thrunner

[ammo 10]

i think its more liquidation of some larger players and will continue til months end,in january when we had that limit down before opening,the nikie was down huge and there was a lot of liquidation in asia,i assume thats happening again,the large hedge funds who talk to each other daily,shopping orders for their customers,know whos in trouble,wait and buy lowere if they know there will be an above average amount of supply,and you get these huge market swings..this is only an assumption

[darthtrader3.0beta 10]

I think the idea that the VIX measures "fear" at this point is simply inaccurate.

If you watch it intraday it almost exactly inversely tracks the index.

I mean its basically telling you how much guys are willing to pay as far as SPX options premium..which I think you have to assume SPX options are mostly a hedging vehicle..so its more of an "uncertainty" index than fear.

If its starting to seem artifically high I imagine that is just because we are getting use to this insane volatility..YM today opens, jumps up 150 points, drops 300, then up 200 and we don't even think about it now.

[Frank 10]

yes, there is a good relationship between 'liquidity' & volatility... Liquidity may be artficially high due to over-leverage -- as we had a few years back.

 

read this blog done 15 months ago by the author of truly prescient book written 6 months before that:

 

http://rick.bookstaber.com/2007/08/can-high-liquidity-low-volatility-high.html

 

THURSDAY, AUGUST 23, 2007

 

Can high liquidity + low volatility = high risk?

Lower volatility can mean higher risk. Here is how I think we get to this paradoxical result.

 

With the growth of hedge funds over the past few years, more and more capital has been scavenging for alpha opportunities. When anything moves a little out of line, there is plenty of money ready to pounce on it. That is, there is more liquidity. And this is great for the liquidity demanders – for example a pension fund that has to invest a recent inflow – because they don’t have to move prices very far to elicit the other side of the trade. And that means lower price volatility.

 

The lower volatility in turn leads to higher leverage. One reason is that many funds base their leverage on value at risk, and they calculate value at risk using historical volatility. So when there is lower volatility they can lever more and still stay within their VaR limits. A second reason is that as more capital flows into the market and as leverage increases, there is more money chasing opportunities. Alpha from the opportunities is thus dampened, so a hedge fund now has to leverage up more in order to try to generate its target returns. And so the cycle goes – more leverage leads to more liquidity and lower volatility and narrower opportunities, which then leads to still higher leverage. This cycle is not much different than the classical credit cycle – which it is a part of this time around – where financial institutions make credit successively easier and easier because of competitive pressure and an environment that has, up to that point, been clear sailing.

 

This then gets to the higher risk. Because the real risk in the markets is not the day-to-day volatility, it is the risk of a crisis. And as I argue in A Demon of Our Own Design, high leverage is one root cause of crisis.

 

Bernanke has said the hedge funds “provide a good deal of liquidity in the markets and help the markets work more efficiently.” And that should be good, right? Well, it depends on how they are getting that liquidity. If it is through leverage, there may be a cloud inside that silver lining.

 

This relationship between liquidity, volatility versus risk is hard to observe, because there is nothing in the day-to-day markets to suggest anything is wrong. In fact, with volatility low, everything looks just great. We don’t know that leverage has increased, because nobody has those numbers. We don’t know how much liquidity will be forthcoming if there is a market stress, nor do we know how many of those who are the liquidity providers in the normal, quiet market times will move to the sidelines, or turn into liquidity demanders themselves. On the surface, the water may be smooth as glass, but we cannot fathom what is happening in the depths.