"I don't know, I don't care, and it doesn't make any difference!" – Jack Kerouac

Volatility can be loosely defined as the relative rate at which the price of a security vacillates based on an annualized standard deviation of the daily change in price, or in other words, the amount of a security’s uncertainty or risk based on frequent changes in its market value. Implied volatility is linked to future uncertainties, whereas actual volatilities are linked to measurable historic events.

The question before us now: Is the sustained lull in volatility we’ve observed over last few years across the financial markets finally winding to a close? A closer look at some widely accepted measurements of volatility suggests that a paradigm shift toward higher volatility and more erratic price action across the capital markets may be emerging. What is behind this rise? Is the trend here to stay? And most importantly, what perils or rewards does it hold for your institution’s balance sheet?

Key Metrics: How to Track Volatility
Two widely used tools for tracking volatility are the Merrill Lynch Option Volatility index (MOVE), and the Lehman Brothers Option Volatility index (LBPX). The MOVE index, which is a yield-curve-weighted index of normalized implied volatilities on Treasury bond options, has recently crept above a reading of 70.0—well off of its low point this year of 56.1. Meanwhile the LBPX index, a weighted average of implied basis-point volatilities of a basket of liquid swaptions, is now north of 80.0, up from a year-to-date low of 72.6.

Figure 1: LBPX and MOVE Indices

A closer examination of both the MOVE and LBPX reveals both indices have risen sharply, suggesting a shift toward higher absolute volatility levels in both the U.S. Treasury and interest-rate swap markets, two fundamental elements of the interest rate markets. We know that the Treasury yield curve has flattened steadily ever since the FOMC started tightening monetary policy in mid-2004, and their data-dependent pause of the last year has served to contain volatility within the context of its historical lows. More recently, however, we have seen a move toward higher yields, particularly in the long-end, as the yield curve begins its renormalization process, from inversion to a positive slope (see graph below). This trend, which serves to perpetuate while simultaneously reacting to greater volatility, is attributed to a host of factors, including but not limited to:

• The collective toll of the subprime fallout and the related CDO downgrades by the ratings agencies
• Heavy private equity/LBO activity stressing leverage and capacity to the outer limits
• Less vigorous sponsorship by foreign central banks in the long-end of the Treasury curve as they diversify into other asset classes
• Growing signs of inflation coupled with persistently robust employment data dimming hopes of a Fed ease anytime soon
• Thunderball returns in the equity market from strong corporate earnings, share buybacks, and M&A activity

Figure 2: 2-Yr/10-Yr Treasury Curve versus Fed Funds Target Rate June 2004 to Present

In addition to U.S. Treasury bonds, swaptions are another important indicator of the possible direction of interest rates. Swaptions are derivative instruments that give the holder the right, but not the obligation, to enter into an interest rate swap at a pre-determined price on a future date. Widely used as a hedging tool, swaptions can be viewed as the insurance market participants are willing to pay to reverse their risk from fixed to floating and vice-versa, thus serving as a measure of implied interest rate volatility linked to future uncertainties. Although it has been more muted lately, given higher interest rates and slowing mortgage activity in many parts of the country, implied swaption volatility is certainly on the rise and is something market participants will watch diligently for signals.

Beyond the Rates Markets: Other Sources of Rising Market Volatility
In addition to the interest rate markets, increased volatility has revealed itself across other financial markets. For example, the Dow finally passed the 14,000 mark for the first time in intraday trading on July 17, just as the Chicago Board Options Exchange implied volatility index (VIX) has been steadily climbing. The VIX reflects a market estimate of future volatility based on a weighted average of strikes on S&P 500 index options.

Figure 3: VIX Index

Equity and fixed-income markets have traditionally moved in opposite directions because the investor base has different motivations and goals. Despite some recent challenges to traditional notions of market correlation (old thinking: correlation was obvious and reliable; new thinking: the globalization of capital is challenging traditional market correlations), volatility in equity markets has climbed, just as it has in the fixed-income markets, with each market’s respective volatility feeding off the other and leading to more erratic price action and less certainty in both markets.

Finally, in addition to rising volatility in interest rate and equity markets, we have seen greater price movements in the credit markets. Both credit spreads and credit protection in the form of credit default swaps suggest the corporate “debt bubble” of the last year or so may be coming to an end. Corporations across the credit spectrum, ranging from investment grade to high yield (“junk bonds”), have been tapping the debt markets for cheap funding due to heavy investor demand for assets. The increased demand has been created by the cash glut from stellar stock market returns, the global commodities boom, and the advent of financial engineering products that allow investors to carve-up and disperse risk, according to investor appetite, through the use of collateralized debt and loan obligations. Recently, however, the go-go debt markets have slowed as investor appetite has begun to wane and the market is showing some signs of resistance in the form of rising debt spreads and wider credit-default swap spreads, reflecting more concern over defaults, rising interest in buying credit protection, and demand for higher returns for risky assets by increasingly skittish investors. As an aggregate measure of corporate debt spreads, we can take a look at the SPIG index, which is Standard & Poor’s option-adjusted spread composite of investment grade and speculative debt issues calculated above the U.S. Treasury yield curve. And for a complete picture, we’ll also turn to the CDX North American Investment Grade Index to analyze the cost of credit protection investors pay to hold debt. Both corporate debt spreads and the cost of default protection as defined by the SPIG and CDX indices are rising in reaction to greater market volatility, while once again wider debt and credit default swap spreads are feeding the rising volatility we’ve seen in other financial markets.

Figure 4: Corporate Debt Spreads (SPIG) Versus the Cost of Credit Protection (CDX)

Increased Volatility: Friend or Foe?
Now that we’ve established volatility is likely rising, how do you make sense of it all? Generally speaking, higher volatility is a good thing for the capital markets, and this latest jump-up seems to be considered a welcome change by many market participants. However, higher volatility should be a warning for those who are vulnerable to interest-rate destabilization, or to those who grew too comfortable in the range-bound market of the last few years.

Now is the time to protect your balance sheet against rising volatility by taking advantage of the options included in the Seattle Bank’s cost-effective and accounting-friendly structured advance products. After all, options only become more expensive to buy as volatility increases.

Knowing your institution’s A/L profile is key to navigating the tricky volatility waters safely. In the end, higher volatility can be a welcome change if you’re prepared for it, and knowing the direction of volatility does matter—despite the words of the famous Jack Kerouac!

By Jonathan Hartley, Institutional Sales and Trading Manager at the Federal Home Loan Bank of Seattle.

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