Price and Value Are Increasingly Distorted in Markets
In his 1986 paper “Noise,” Fisher Black -- the Goldman Sachs economist who developed the Black-Scholes option pricing model with Myron Scholes -- discussed two kinds of volatility: price and value. According to this theory, when there is short-term volatility in the prices of assets, the long-term value of those assets can be affected.
In Black’s analysis, there is a distinction between what causes volatility: noise or information. In today’s markets, given the heated election rhetoric in Europe, tweets from the White House and geopolitical saber rattling in Asia, it’s more important than ever to understand the interplay between noise, actionable information and ultimately value.
In general, noise causes short-term volatility in prices, whereas information can alter valuation. Sometimes the two collide, and when that happens, options on stocks, bonds, commodities and currencies become "overpriced," affecting the value of underlying assets. According to Black, the situation should correct itself once investors are able to sift through the noise.
Take yields on shorter-maturity U.S. Treasuries. Federal Reserve officials have made it clear in recent weeks that it is ready to accelerate the pace of interest-rate increases. The comments caused traders to reprice the probability of a hike this week, and the price volatility of federal funds futures expiring in April and May has skyrocketed. The volatility of Treasury note futures, however, has fallen. If Black's logic were to be followed, options tied to fed funds futures may appear “overpriced” because the Fed’s initial message could be seen as noise. Nonetheless, with a probability of a March hike close to 100 percent, noise has become information. Thus, if the implied volatility of fed funds futures were to be used to price U.S. Treasury futures, the value of long-term Treasury bonds could be quite different.
To see why this is the case, look at the next graphic. Short positioning in Treasury futures by noise traders (i.e. short-term speculators) exceeds those positions held by value investors (i.e. asset managers). The positioning suggests a possible inflection point in Treasury markets, suggesting that an attempt to breach 3 percent on the 10-year Treasury yield is possible.