Maybe Markets Aren't Complacent at All

Equity volatility is at its lowest levels since the VIX was first calculated. Since 1990, 26 days have seen the VIX close below 10. Seventeen of those days have been this year, and 10 have been in the last month. One trivial reason for the persistently low VIX is that realized volatility has been even lower. Since the start of July the average VIX level has been 10.26 but close to close realized S&P volatility has been even lower at 5.9%.

This is obvious, but also means that the “option markets are complacent about risk” argument doesn’t hold water. The actual market isn’t moving so no one is going to pay a lot for S&P options or VIX futures in this environment. The real question is, “why isn’t the market moving?”

Prices and volatility are the aggregate of market participants views. If all investors have the opinion that volatility will be large then it will be. But another way volatility can come about is if all the traders have different views of future returns. Here is a very simple example. Think of a market with two traders. They both think volatility will be 30%, but one thinks the return will be 10% and the other thinks it will be 30%. The average of these two opinions will have a volatility of 40%, higher than either’s view of market risk. This is because the total variance is the average variance plus the average squared mean minus the square of the average mean. This effect is shown in Figure One:

Figure One: A mixture of normal distributions (grey) has a higher variance than the components(blue and orange).

So it is entirely possible that the current low volatility is the result of converging return estimates rather than any concept of lower intrinsic risk. This seems like a tough hypothesis to test, but also give a possible counterpoint to the idea that traders have a lowered expectation of risk.