Robert Engle: Hello, I’m Robert Engle. I’m a professor of finance at the Stern School of Business of New York University. We are here in the heart of Manhattan and we’re going to talk about volatility.
Volatility’s a subject that’s very close to my heart because I won the Nobel Prize for my volatility research in 2003, but this is a topic that’s of interest to everybody. It’s of interest to traders in Wall Street, it’s of interest to CEOs of major corporations and it’s of interest to individual investors.
We’ll spend five days talking about various aspects of the measurement, the explanation and the consequences of volatility in our complicated, modern world. So why don’t you come on up to my office and let’s begin.
Welcome to my office. We’re going to talk about volatility. We’re going to talk about volatility of financial markets and take a global perspective. When I say volatility, I want you to think about the newscaster who comes on the news every day and says the market is up or the market is down. If those are big numbers, then we say the volatility is high; if they’re small numbers, volatility is low.
It’s this kind of a bumpy ride that makes investors uneasy about investing in the stock market, or in fact in any other financial asset. But in fact, the volatility is an essential part of financial markets because otherwise they wouldn’t be able to do their job. They wouldn’t be able to allocate resources to the highest and best companies because if prices never changed then there would be no chance for small companies to become large companies or large companies to decline.
So volatility is a key feature of financial markets. And I’d like to take you on a little tour of the US financial markets from a volatility point of view.
If we look at the first slide, you can see what’s happened to the Standard and Poor’s 500 asset price for the last 40 years. In the blue curve you see on the left has started at a low value and has basically risen dramatically over this 40 year period with a fairly sharp decline at the end of the sample. From a volatility point of view we’re going to be interested in the rate of change of that index, and that’s shown on the top. For every day we look at how much it changed from the previous day. The top curve is a volatility picture, and when we say that the volatility is high, what we mean is the amplitude of that curve is high, and when volatility is low, the amplitude is low.
So let’s take a look at a couple of episodes. Turn to the next slide. We see that the periods when volatility is high are exactly the same as the periods when the market is in decline. So, you look below an episode of high volatility, you can see in the blue curve, the market is declining.
If you look on the next slide we see the period in the middle 90s when volatility was very low. In fact it was a record low for the time. That’s when I first started consulting for Wall Street, and when I went to Wall Street they asked me, why is volatility so low and is it likely to stay low? One of the things I had learned about volatility was that it tends to mean revert so that when it’s low, ultimately it comes back up again, and when it’s high, ultimately it declines.
Well, it turns out that was the right answer. As you can see by looking further to the right on that graph, when we came to the market increase around 2000, which we now call the internet bubble, we see very high volatility corresponding to high levels of risk for stock investing at that point in time.
And on the next slide you see what happened afterwards. The market turned down. We had a substantial decline in the level of the S&P 500 but we also had high volatility as this market declined. So this is all a discussion about stock market volatility, but what about other financial assets? In fact all financial assets have some degree of volatility and we can take a look at what it is.
If we look at the next graph we have a chance to look at the volatility by asset class, and what we’re calculating is the standard deviation of the returns calculated on an annualised basis for a period from 1997 to 2003. And the first bar on this chart is for IBM stock. The volatility for IBM is about 40 per cent, and that means that if you invested in a portfolio which was just IBM stock, this portfolio would have a volatility of 40 per cent. If you look at other large-cap stocks like General Electric and Citigroup and McDonalds and Wal-Mart, you see those are all between 30 and 40 per cent. This is a lot higher than the S&P itself, which has a volatility of about 20 per cent over this period, as you can see in the next bar on the chart. And that illustrates immediately the advantage of diversification because the broad index has a lower volatility than its components.
Looking further on this chart you can see some small-cap companies that have volatilities that range from 30 per cent to 70 per cent, and some small-caps have much higher volatility even than this. Fixed income assets also have volatility because interest rates change, and if you look at the next segment of the graph you can see a small green square which illustrates the volatility of the one month treasury bill. That is very low, which means it’s a very safe, un-volatile asset. The five-year bond is a little more volatile. The 20-year bond has a volatility of about 10 per cent.
So the question that you probably are wondering is, why are these volatilities different across asset classes? Is there anything that we can say from economics that would help us understand those differences? Well, I think the answer is yes, but the first thing we have to do is we have to say, why are asset prices what they are anyway?
The price that you’re willing to pay as an investor for a share of a company stock depends on what you think the future profits of this company’s stock are and how long you’re going to have to wait to get them. The more profitable the company, the more you’re willing to pay for its stock. Some assets are more volatile than others. We have to talk about how important the news is.
For small-cap stocks the news is very important. We really wonder whether a small -cap stock is the next Microsoft or whether it’s going to go bankrupt. Every piece of information that tells us whether this is an up-and-coming company or one that’s not going to make it, is tremendously important, so the volatility of small-cap stocks is very high.
So this news theory of volatility is pretty successful in explaining the qualitative features across asset classes. What about across countries? Could we use this news theory to explain the difference in volatility across countries?
Well, on the next graph we’ve got the median volatility of the equity markets of each of about 50 countries over the same sample period, 1997 to 2003. And what you’ll see is that these median volatilities range from about 10 per cent to about 50 per cent. So that is, they range from the volatility of the bond market to the volatility of a small-cap stock. What do we see when we look at the countries? Well, the low volatility countries are Chile, the UK, Australia, New Zealand, Austria, Canada and a few others. The high volatility countries are Turkey, Korea, Brazil, Finland, Russia and many others, and there’s a whole range in between. Can we talk about the news in a way that enables us to explain why these countries are different from each other?
Well, you’ll have to wait because we’re going to have to develop some more tools before we can do that, but that’s going to be one of the goals of our research this week.
Come back tomorrow and we’ll talk about measuring volatility when it’s changing over time.