What Flipping Coins Tells Us About ‘Turbocomplacency’ in MarketsBy
Deutsche Bank derivatives analyst warns of disorderly unwind
Abnormal volatility is increasing the penalty for dissent
Heads or tails? To understand how markets are underpricing the risk of a selloff, simply flip a quarter and bet on the outcome.
So says Aleksandar Kocic, derivatives analyst at Deutsche Bank AG, who argues in a new note that the coin-based analogy can help explain the “turbocomplacency” that has overcome markets over the past five years.
In Kocic’s coin-tossing example, heads pays out $10 and tails delivers nothing. With such terms, and a 50 percent probability of either outcome, players are unlikely to bet $5 -- the expected value of the trade -- on each toss. Instead they’ll be looking for an edge, and a $4 bet, for instance, would give them an advantage big enough to justify playing.
On that basis, the risk premium for playing -- or the difference between the expected price of the trade ($5) and the price at which it’s realistically traded ($4) is $1. In other words, there are two factors at play -- the mechanics of the coin, with its 50 percent probability of heads or tails, and the price investors are willing to pay to make a bet on it.
The Coin and Markets
To apply the example to markets, Kocic compares the coin flip to the Global Economic Policy Uncertainty (EPU) Index. And he compares the risk premium being asked for by investors to the Chicago Board Option Exchange’s Volatility Index, now languishing at historic lows.
“Until 2012, for the most part -- but not always -- both levels and spikes tend to be coordinated across two measures. When VIX is in tune with EPU, the market is acknowledging the levels of risk through prices,” writes the analyst. “After 2011, the two measures of risk decouple with the VIX consistently low despite growing uncertainty. The breakdown is structural, and it is visible across all market sectors, not only equities.”
What explains the seeming disconnect between uncertainty and what the market is paying up for risk? Or, as Kocic phrases the question, “have the markets changed, or was it actual uncertainty that is different now? Is it our risk appetites or the ‘coin’ that are different?”
By his reckoning, it’s both. The price of not making a bet on markets has increased substantially thanks to herding behavior and the presence of a central bank put which has “abnormalized” market volatility and rewarded those who bet against a selloff.
Meanwhile, a steady stream of warnings about rising levels of uncertainty is falling on the increasingly deaf ears of investors. “When we operate under information overload, we tend to defend ourselves by filtering excess information. It means we are deliberately underplaying the importance of its content and implicitly questioning credibility of its sources,” he writes. “And the more we ignore their warnings, the more they will be warning us.”
“This is what everyone is talking about. Despite growing uncertainties and tensions, the market volatility refuses to rise,” he says. “Persistence of low volatility is increasing the penalty for potential dissent and reinforces one-sided positioning. As a consequence, the risk of disorderly unwind is growing.”