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Zero Volatility


Volatility in all stocks and the market has come down precipitously and in general terms, is at its lowest level in five years. That means that investors are more comfortable selling options, and therefore with the level of the market, than they were before 9/11.

How is this possible? With the new exogenous factor of "economic uncertainty" due to terrorism (I believe the real target of terrorism is the economic system), a rational conclusion would be that volatility would have an inherently higher fair value. In addition, the dramatic increase in liquidity to mitigate the economic harm has left the system with much higher debt, another factor that would normally increase volatility.

I cannot speak to the economic uncertainty factor. Perhaps I am imagining it. If it exists, investors are choosing to ignore it. This type of risk will not necessarily increase day to day volatility, but it should significantly increase tail volatility. This is measured by the skew (as I have described in the past). Although a steep skew (representing increased tail risk) at first was predominant in the market, it has now all but disappeared except in a few select names (like the airlines).

Secondly, the added liquidity in the short run tends to reduce volatility. The flood of money has mostly found its way into financial assets: with nothing else to do on a return basis, investors have slowly but surely increased their tolerance for risk (I maintain unwittingly). This creates a bid underneath the market for equities, so any drop in the market has been short lived.

At some point this extra liquidity will be sopped up, either through operations by the Federal Reserve or by it going into real assets instead of financial ones. When this happens, we will still be left with the debt.

This has nothing to do with market direction. My main point is that volatility at these levels can catch a bid from nothing at all, as evidenced by today.
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