By Kostas Deslis
Implied volatility can be a useful indicator in making informed investment decisions and points to some turbulence from here.
Implied volatility measures market participants’ expectations of how much an asset’s price will fluctuate over a given period. According to a 2006 study by the Chicago Board Options Exchange (CBOE), implied volatility is a better predictor of future realized volatility than historical volatility, which is based on past price movements. This suggests that market participants’ expectations, as reflected in implied volatility, maybe a more accurate reflection of future price movements than past price movements.
Where do we stand now? In the current market, after volatility normalized at the beginning of the year, a huge pick-up in cross-asset volatility occurred in March, led by a sharp increase in interest rate volatility. Most interestingly, the U.S. front-end – as measured by expected one-year volatility on short-term interest rates – reached extremes of more than 300 basis points, implying a huge dispersion of potential outcomes over the coming 12 months. In relative terms, implied volatility for stocks as measured by the CBOE Volatility Index (VIX) remains subdued, standing at an average of 19% since the beginning of 2021. Compared to low-volatility regimes in cross-asset markets, such as in 2017 – 2019 (with an average VIX level of 15%), this is just 25% higher. Conversely, the Merrill Lynch Open Volatility Estimate (MOVE) index, which measures interest rate volatility, is 50% higher at an average of 100bps versus annualized volatility of 66bps in low-volatility eras.
When it comes to short-term moves, currencies have the most liquid short-dated volatility market. U.S. dollar/Japanese yen volatility has been one of the most observed and traded assets this year, and its term structure still suggests an elevated front-end risk premium, with current one-month to three-month volatility higher than one standard deviation relative to the five-year average, suggesting currency as well as rates volatility, as the dollar/yen is highly correlated to both global and U.S. rates, and expected to remain high.
It’s important to remember that periods of high implied volatility are often associated with market downturns, while periods of low implied volatility are often associated with market upturns. When implied volatility is high, it indicates that the market is pricing in a higher degree of uncertainty or risk, which can lead to sharp moves. Overall, we expect to see continued bouts of short-term volatility, throughout the year, across various markets, as the options markets seem to imply.
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