Markets: Preparation for volatility a must

Low volatility, in general, means low risk, which highlights another anomaly -- when any asset gets into uncharted territory, risk, almost by definition, should be high, notes Jamal Mecklai.

Globally, equity markets are rocking.

Driven by liquidity and a growing belief that the US economy is finally recovering, the Dow is at an all-time high and is hovering around 15,000+.

However, its volatility remains extremely low at nine per cent and is, in fact, falling. The previous time it reached an all-time high (of 14,000+) was in 2007, before Lehman hit; at that point its volatility was over 18 per cent.

Over a longer history, too, current Dow volatility is remarkably low -- 40 per cent below its 10-year average.

Low volatility, in general, means low risk, which highlights another anomaly -- when any asset gets into uncharted territory, risk, almost by definition, should be high.

Several other assets, too, are at extremely low volatilities from a historic perspective -- sterling and euro volatilities are each nearly 20 per cent below their 10-year averages; the volatility of copper is 28 per cent below its long-term average; oil volatility is 48 per cent below its historic average and the volatility of the Sensex is 49 per cent below its long-term average.

From these numbers and the fact that volatility is mean-reverting, it should be clear that there is an increasing risk of a rise -- perhaps, dramatic -- in global volatility.

To complete the picture, we should also look at a couple of wild cards that are already stirring this low-volatility pot.

The volatility of gold, which took a step jump when the price fell sharply over two days a month ago, is 26 per cent higher than its long-term average.

And then there’s the really wild bugger, the yen -- its current volatility is fully 56 per cent higher than its 10-year average.

Interestingly, and, perhaps, unsurprisingly, both of these volatilities had also hit major lows just recently.

Gold volatility reached a low of around 11 per cent in February this year, at which point it was 40 per cent below its 10-year average; since then it has doubled to 22 per cent.

Yen volatility also hit a multi-year low (again, 40 per cent below its long-term average) in October last year, and has risen by 67 per cent since then.

Most of the quieter assets mentioned earlier have also seen their volatility rising recently, with copper volatility up 41 per cent and oil volatility up by 30

per cent in the past month, confirming that risk is rising in asset markets.

There are, however, a couple of outliers that bear closer analysis.

The first is the dollar index, the current volatility of which, like that of many others, is about 25 per cent below its 10-year average, but which has not moved at all in the past month.

A breakout seems imminent here.

And then, of course, there’s the rupee, whose current volatility is close to a one-year low.

Here, too, a volatility breakout is a distinct possibility if global markets do, indeed, get wild.

Perhaps the Reserve Bank of India is looking at the market this way as well, which might explain its sudden strange prohibition on Indian entities owning or investing in global assets that trade the rupee in any way, shape or form.

It would seem this is targeted at domestic players who have -- unsurprisingly and quite easily -- found ways around the no-margin constraint on the $200,000 that each citizen is permitted to invest overseas each year.

While I understand and fully endorse the concept that if someone breaks the law they should be punished, making the rules more difficult to breach is hardly a sensible approach, since human inventiveness knows no bounds.

This is all the more meaningless when it is hard to understand the justification for the rule in the first place.

I mean, if I am allowed to invest $200,000 and I buy shares in some foolhardy venture, I lose my money.

So, too, if I invest $200,000 as margin and trade foolishly, I lose my money. It’s my post-tax money and if I want to burn it, it should be my right.

The RBI should have much more important things to think about than moral policing.

If their intention is instead to try and control onshore USD/INR volatility, the approach is a non-starter.

First of all, the rupee is already a global investment currency and the total volume of non-deliverable and overseas futures markets already exceeds -- or, certainly in short order, will exceed -- onshore volumes.

In fact, the RBI’s 2011 constraints on the domestic over-the-counter market have certainly been instrumental in driving these volumes higher.

Instead, the RBI needs to increase the trading hours on the currency futures markets and accelerate deregulation of the over-the-counter market by widening the user base to consolidate USD/INR trading and bring better risk management opportunities to Indian entities.

In the meantime, people should prepare for higher volatility in most markets -- buy options till you are blue in the face.