Risk Latte - Thirty Five Years of Volatility

Thirty Five Years of Volatility

Team Latte
Sep 07, 2005

Volatility, as we know and understand it today, in the financial markets can be traced back to the year 1971. The following is a chronology of events that ushered in regimes of high volatility into financial markets and all along the following sequence of events volatility has fluctuated quite wildly:

  1. The fixed exchange rate system - Bretton Woods Agreement - broke down in 1971 leading to flexible currency exchange rates (this is the start of volatility in the currency markets);


  2. The first oil crisis of 1973 created high volatility in interest rates and was followed by high inflation (this not only marked the start of volatility in the interest rate markets but also volatility in GDP);


  3. The U.S. stock market collapse in October, 1987 was the harbinger of extreme volatility in the equity markets; this event was also a landmark event due to two reasons - (a) portfolio insurance models as applied to equities became a major subject of analysis for both academicians and practitioners and (b) for the first time the option traders realized that the Black-Scholes model of constant volatilities was unstable and the phenomenon of volatility smile was discovered.


  4. The Japanese stock market (Nikkei225) crashed towards the end of 1989 and within three years the stock index had lost more than 50% of its value; this led to a long and dark period in Japanese capital markets and real economy which lasted almost eleven years and after-effects of the crash caused high volatility in both the equity and bond markets;


  5. Then in 1994 the bond markets in the U.S. crashed that was eventually followed by six consecutive hikes in the short term interest rates; this once again proved that volatility is not only the preserve of the equity markets but also the bond markets;


  6. The Asian financial crisis in July 1997 brought back the nightmares of foreign exchange volatilities and eventually wiped off about three-fourth of the dollar capitalization of equities in Malaysia, Korea, Indonesia and Thailand.


  7. The Russian debt default in 1998 ignited another round of financial crisis in the global financial markets and finally ended up with the bankruptcy of Long Term Capital Management, the behemoth hedge fund.


  8. And finally after a long bull run the sun set on the NASDAQ in early 2000 and the values of internet, technology and new economy stocks melted away in decline that had no precedent and that lasted for almost four years; this was the when the equity volatilities reached an all time peak (as measured by VIX);

Since then volatility has been falling and staying low. The question is when will it rear its head again?


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