Is there a “Normal” Level for Volatility?
Much of modern Financial Economics is built upon a series of assumptions about the markets. One of those assumptions is that the markets are equilibrium seeking. If that was the case, it would seem that it would be possible to determine the equilibrium level, because things would be constantly be tugging towards that level.
But look at Volatility as represented by the VIX…
The above graph shows the VIX for 30 years. It is difficult to see an equilibrium level in this graph.
What is Volatility? It is actually a mixture of two main things as well as anything else that the model forgets. It is a forced value that balances prices for equity options and risk free rates using the Black Scholes formula.
The two main items that are cooked into the volatility number are market expectations of the future variability of returns on the stock market and the second is the risk premium or margin of error that the market wants to be paid for taking on the uncertainty of future transactions.
Looking an the decidedly smoother plot of annual values…
There does not seem to be any evidence that the actual variability of prices is unsteady. It has been in the range of 20% since it drifted up from the range of 10%. If there was going to be an equilibrium, this chart seems to show where it might be. But the chart above shows that the market trades all over the place on volatility, not even necessarily around the level of the experienced volatility.
And much of that is doubtless the uncertainty, or risk premium. The second graph does show that experienced volatility has drifted to twice the level that it was in the early 1990’s. There is no guarantee that it will not double again. The markets keep changing. There is no reason to rely on these historical analyses. Stories that the majority of trades today are computer driven very short term positions taken by hedge funds suggest that there is no reason whatsoever to think that the market of the next quarter will be in any way like the market of ten or twenty years ago. If anything, you would guess that it will be much more volatile. Those trading schemes make their money off of price movements, not stability.
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