Robert Engle: I’m standing in front of the New York Stock Exchange. This is a great place to talk about equity market volatility, because the New York Stock Exchange trades so many equities of funds and stocks that are listed from all over the world. We talked, in the last lecture, about the short run volatilities that are surprisingly low in almost all countries around the world, and yet the long run risks are what we think of as quite high. We are going to try to figure out how we can understand both of those phenomena.
I think it’s helpful to distinguish between short run risks on one hand, and long run risks on the other hand. What do we mean by that? When we measure volatility using a GARCH model, or looking at high frequency data, we see volatility on a short horizon. How much volatility do we have over the near future, over the next few days and the new few weeks? But when we talk about these global risks, like the balance of payments deficit and budget deficits and the war in Iraq, we’re talking about much longer horizons than that, and that’s what we mean by long run risk. Those risks are important to us, and we need to evaluate them.
In fact, Wall Street evaluates these risks all the time. They calculate the cost of insurance, and that shows up in options prices, and we can look at the prices of options that have only one month’s worth of insurance, and options that have two years’ worth of insurance. The implied volatility of these options is a measure of how risky the options market thinks that these two different horizons are.
If you look at the graph for 1999 to 2002, you can see that the two year volatilities, measured in red, and the one month volatility, measured in blue, sort of oscillate between which one is higher. But when you look at the period from 2004 and 2005, you see that the long horizon volatility in red is much higher than the short horizon volatility in blue. That’s even more pronounced when you look at longer maturity options, which are not traded on the exchange, but which are over the counter traded. There, you can see, looking forward up to 10 years in the future, that volatilities rise higher and higher and higher the further out you go in the future. This is not a standard outcome. It’s specific to this point in time.
So, the question really we want to ask next is, what is the implication of having long run volatility so much higher than short run volatility? For financial investors, it might seem that a good strategy is to invest now, while the volatility is low, and worry about the high volatility later. But for more sophisticated investors, it’s natural to think that the investments that you make now, when volatility is low, will lose value when the volatility actually rises in the long run. We can see lots of evidence, if you look around the world, that there is a large amount of savings that is not going directly into investment. It’s being kept and waiting for investment opportunities to look better.
Policy makers can change their policy to solve long run risks or they can ignore long run risks. If they change policy to solve long run risks, there will be immediate benefits through improving stock prices, better investment opportunities for companies, and a better flow of savings from savers to investors.
So, policies which will smoothly solve the Iraq war problem, or policies which will reduce the government’s deficit, or rationalise the balance of payments system would all reduce these long run risks, and therefore provide immediate benefit to the economy. In the next segment, we will analyse the magnitude of these long run risks, and in particular we’ll talk about climate change and under-funded pension programmes, which are important long run risks facing investors today.