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The VIX index of volatility on the S&P100 share index in the US has become a popular measure of the ‘price of risk’. A dangerous and misguided corollaryhas subsequently developed because a ‘low’ price of risk (signalled by the VIX index trading nearer to 10% than its usual 20%) has been taken as a sign of investor complacency. In short, an excessive demand for risk by reckless investors with too much money has pushed down risk spreads to such low levels that disaster surely beckons.
From a law that would merit Newton, what goes down in financial volatility terms must surely come up, thereby leading to a sharp market sell-off? However, we know from basic economics that all prices are determined by the interplay of supply and demand. The fall in the price of risk might be because the demand for risk has jumped, but equally it could be because the supply of risk has dropped.
Indeed, we believe that this is the case. Risk generally has two components: a monetary term, relating to the supply of credit, and a real economy term, relating to the production of value or profit. Let us assert that the greater stability of the Western economies over the past two decades has contributed to lower volatility through this second term. However, we think that better management of credit is the key reason why financial volatility has fallen. The best way to see this is in forex markets.
The parallel drop in forex market volatility compared to the drop in the VIX is no coincidence. In fact, there is a logical and empirical sequence that links forex market volatility to bond market volatility, and bond market volatility, in turn, to stock market volatility, or FIX, BIX and VIX! Since Central Banks largely determine currency values, the low level of the VIX must result from the low level of FIX. Investor complacency or Central Bank complicity?
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