Volatility, Bonds And the Russian Market: May the Fourth by Jared Dillian, Mauldin Economics
I recently watched the movie Interstellar in the theater. I liked it so much, I watched it again⌠and again. Three times in 10 days. Next, Iâll get the DVD and see it dozens of more times. Itâs my new all-time favorite movie.
Iâm something of an astrophysics geek. I think in another life I might have been one of these nerds working for the SETI project like Ellie Arroway in Contact. For my fifth-grade science project, I constructed a planetarium show. When my schoolmates were playing Contra on Nintendo, I was reading about quasars.
Interstellar fascinates me because I donât understand how someone gets $150 million of financing to make a movie that no one who doesnât understand Einsteinâs theory of relativity can fully appreciate. Christopher Nolan is a stud. There is no other explanation.
I had to smile each time I left the theater, listening to the people walking out. âI didnât understand any of that!â they would say. I think knowledge of the cosmos is pretty low in my corner of South Carolina.
I wonât spoil it for you, but letâs say thereâs a lot of physics knowledge required for that movie. Incidentally, thereâs a lot of physics knowledge required for trading too.
The derivatives guys understand this. Most conventional option pricing models are based on something called âgeometric Brownian motion,â which was originally used to describe the movement of a particle suspended in a liquid or a gas.
Emanuel Derman, author of My Life as a Quant and contributor to the Black-Derman-Toy model that pioneered the pricing of bond options, started out as a darn good physicist. Then he was hired by Goldman Sachs Group inc. Lots of quants (quantitative analysts) are former physicists. Finance and physics really are that similar.
I have my own theories about financial physics.
- Stocks and bonds are matter. They are things. They are particles. They literally are physical objectsâin the old days, certificates. Nowadays, they have a CUSIP. You can clip the coupons. In bearer form, they were worth money. Nowadays, nobody really gets to hold a bond in his hand, but itâs still tangible as far as Iâm concerned. The foregoing also applies to currencies. And commodities⌠well, they are as tangible as you can get.
- Credit and volatility are not matter. They are forces very similar to gravity. Think about it: credit is the willingness or ability to repay. Itâs a feeling, a sensation, a psychological construct. But it is not a thing. It has neither a certificate nor a CUSIP. But credit is directly related to volatilityâotherwise the credit guys wouldnât hedge with VIX call spreads all the time.
The one thing we know about gravity is that it is not constant in the universe. There can be large disturbances, like a black hole, where time can actually slow downâexactly like the gravitational time dilation described in Interstellar. When volatility increases (and credit widens), options decay more slowly. Volatility (âvolâ) and time work in opposite directions.
Vvol Is Sky-High Right Now
We are currently experiencingâIâm grinning as I write thisâdisturbances in the force. Credit and volatility have never acted this way before, and I can quantify it exactly.
Never before has the VIX gone from 11 to 20 in just four days. A few weeks ago, I wrote about the outsize influence volatility ETFs were having on the vol complex, and that remains true. I think this can partially be explained by people panicking out of XIV, the VelocityShares Daily Inverse VIX Short-Term ETN.
But itâs actually bigger than that. Volatility is itself volatile. You can measure the volatility of volatility; traders call it âvvol.â And the only times vvol has been this high since the advent of VIX options were in 2007, 2008, and 2011âall times of serious crisis.
But we arenât in a crisis now, are we?
Well, we might be, if you think vvol has any predictive power, as I do. Certainly nothing of the magnitude of â07,  â08, or  â11. But when youâre having 700-point intraday round trips in the Dow and vvol is at crisis levels, I think itâs time to start asking the hard questions.
â⌠Where No Man Has Gone Beforeâ
The bigger picture is: Russia is experiencing a full-blown currency crisis, whether anyone is calling it that or not; emerging markets are in meltdown mode (as predicted by some of my colleagues here at Mauldin Economics); and the price of the single most important commodity in the world has just been cut in half in the span of a month or two.
These are not normal times. And the bull market in stocks is very, very advanced.
Even though I write for a living, Iâm a former trader, so I still spend my days staring at the screens. I havenât seen anything like this before. New territory hereâand not in a good way.
But Iâm a student of volatility and credit, and I paid attention in early 2009 when no put option was too expensive and no bond was safe. It feels as if something like that might be in our future.
Jared Dillian
Editor, The 10th Man
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