The Factors affecting stock market volatility
----Dr.
Debesh Bhowmik
We learnt from recent theoretical
explanations that the countercyclical behavior of stock volatility can be
understood as the result of a rational valuation process. However, how much of
this countercyclical behavior is responsible for the sustained level aggregate
volatility has experienced for centuries? Approximately one third of this level
can be explained by macroeconomic factors, and that some unobserved component
is needed indeed to make stock volatility consistent with rational asset
valuation. Moreover, it is shown that a business cycle factor is needed to
explain the inevitable fluctuations of stock volatility around its average.
The risk-premiums arising from fluctuations
in this volatility are strongly countercyclical, certainly more so than stock
volatility alone. In fact, the risk-compensation for the fluctuation in the
macroeconomic factors is large and countercyclical, and explains the large swings
in the VIX index during recessions. When the VIX reached a record high of more than
70%, which the model successfully reproduces, through a countercyclical
variation in the volatility risk-premiums. Finally, it is evident that the same
volatility risk-premiums might help predict developments in the business cycle
in bad times and the end of a recession.
Which macroeconomic factor
matters? It was found that industrial production growth is largely
responsible for the random fluctuations
of stock volatility around its level, and that inflation plays, instead, a
quite limited role in this context. At the same time, inflation plays an
important role as a determinant of the VIX index, through two channels: (i)
one, direct, channel, related to the inflation risk-premium, and (ii) an indirect
channel, arising from the business cycle propagation mechanism, through which
inflation and industrial production growth are correlated. The second channel
is subtle, as it gives rise to a correlation risk that it is significantly
priced by the market.(Corradi,Distaso &Male,2010).
Fig-1,VIX index
The key aspect is that the
relations among the market, stock volatility, volatility risk- premiums and the
macroeconomic factors, are consistent with no-arbitrage. In particular, volatility
is endogenous in our framework: the same variables driving the payoff process
and the volatility of the pricing kernel, and hence, the asset price, are those
that drive stock volatility and volatility-related risk-premiums. A question
for future research is to explore whether the no-arbitrage framework in this
paper can be used to improve forecasts of real economic activity.
In fact, stock volatility and
volatility risk-premiums are driven by business cycle factors. An even more
challenging and fundamental question is to explore the extent to which business
cycle, stock volatility and volatility risk-premiums do endogenously develop.
The volatility in global equity markets
since late summer 2011 continues to attract widespread media and investor
attention. Much of the commentary has focused on perceived causes for the volatility—such
as the growth of hedge funds, high-frequency trading, quantitative investment
programs, and vehicles such as exchange-traded funds (ETFs), specifically,
leveraged and inverse ETFs. Little focus, meanwhile, has been placed on the
global macro environment, which faces the continuing Eurozone debt crisis; the
prospect of a slowing global economy; political brinkmanship in Washington,
D.C., including the failure of the super committee created by the U.S. Congress
to help reduce the national debt; and the rating downgrade of U.S. Treasury
bonds from their AAA status by Standard & Poor’s in early August 2011.
Fig-2: Daily percentage change in price of S &P 500 index
All investments are
subject to risk. Foreign investing involves additional risks, including
currency fluctuations and political uncertainty. Investments in bond funds are
subject to interest rate, credit, and inflation risk. U.S. government backing
of Treasury or agency securities applies only to the underlying securities and
does not prevent share-price fluctuations. Unlike stocks and bonds, U.S.
Treasury bills are guaranteed as to the timely payment of principal and
interest. Diversification does not ensure a profit or protect against a loss in
a declining market. There is no guarantee that any particular asset allocation
will meet your investment objectives or provide you with a given level of
income. Past performance is no guarantee of future returns. The performance of
an index is not an exact representation of any particular investment, as you
cannot invest directly in an index.
Fig-3: Relationship between equity
market volatility and economic volatility
“Volatility
in economic conditions” is defined here as the annualized rolling standard
deviation over 36 months through December 31, 2011, in the Federal Reserve Bank
of Philadelphia’s Aruoba-Diebold-Scotti Business Conditions Index, which is
designed to track real business conditions at high frequency. The index’s
underlying (seasonally adjusted) economic indicators (weekly initial jobless
claims, monthly payroll employment, industrial production, personal income less
transfer payments, manufacturing and trade sales, and quarterly real gross
domestic product) blend high- and low-frequency information and stock and flow
data. Volatility in the S&P 500 Index is defined here as the annualized
rolling standard deviation over the 36 months through December 31, 2011, in the
price returns of the index.
Fig-4: Intraday
volatility is calculated as daily range of trading prices (high–low/open) for
the Dow Jones Industrial Average.
To be sure, the 2000s have so far
witnessed two severe bear markets and an extreme level of volatility and risk
during the global financial crisis, yet it’s important to note that between
2003 and 2007, stock market volatility and risk aversion were at all-time lows
historically. And when we compared the first decade of the 2000s and 2011 with
long-term history, do not support the theory. In fact, Figure 3 shows that
volatility since 2000 has been on a par with the long-term averages (i.e.,
1929–1999).
Standard deviation of S&P Index
returns for selected periods:
Lasly, We also know that
realized volatility is a critical factor in the equity risk premium (ERP)—that
is, the extra return demanded by investors for investing in stocks instead of
less risky assets such as bonds or cash. Indeed, periods of heightened
volatility or risk can actually increase the forward ERP. Fortunately,
according to data from Morningstar, most investors are not solely invested in
equities, but instead have a mixture of assets that prevents them from being
fully exposed to sudden stock market volatility. So, although we
understand that these can be unsettling times for investors, those who have
determined an appropriate asset allocation, who employ broad diversification,
and who rebalance as necessary are in a better position to weather this period of
uncertainty, as well as the inevitable market dislocations to come.
The political history showed that
during the Great Depression, aggregate stock market volatility in a large number
of advanced economies reached levels not seen before or since. Schwert (1989b)
estimates that in the US, there was a two- to threefold increase in
variability. According to his measure, the monthly variation of stock returns
peaked at over 20 percent in 1932. Other developed countries experienced
similar increases in volatility. This is all the more puzzling since macroeconomic
series such as money growth and interest rates showed markedly smaller
increases in variability . As a general rule, neither wars nor periods of
financial panic appear to lead to significantly higher variability of equity
returns over an extended period — despite the highly unstable behavior of other
macroeconomic series. Recessions, however, are clearly associated with higher
volatility . The argument that political risk during the Great Depression is partly
to blame is supported by the recent finding that unusually high levels of
synchronicity of individual stock returns contributed substantially to
aggregate volatility .
The data on civic unrest and
political stability is from the cross-national data set compiled by Arthur
Banks under the auspices of the Center for Comparative Political Research at
the State University of New York. In addition to a set of demographic and
economic variables, it also contains information on the nature of the political
system and social instability for a set of 166 over the period 1815-1973.
Overall, the interwar data set for a number of countries that are developed
today shows a relatively high level of political instability and violence. For
most indicators of political uncertainty, the levels are twice the average
observed in the larger data set. This is true of the number of assassinations,
of general strikes, government crises, riots, and anti-government
demonstrations. In three categories, the subsample actually appears more stable
- there were fewer revolutions, purges and acts of guerrilla warfare than in
the 166 country sample. The variability of the measures of political
instability is considerable, ranging from a coefficient of variation of 3.9 in
the case of revolutions to 1.98 for government crises. While Germany scores
very high on almost all measures of political fragility, recording a total of
188 events of unrest, Switzerland marks the opposite extreme. Only three acts
indicating instability are recorded - two assassinations (in 1919 and 1923) and
one riot (in 1932). There is also plenty of change over time. While 1919 saw,
for example, four times the average number of assassinations in the subsample
of 10 countries, there were none in 1936-38. The number of anti-government
demonstrations reached more than twice is average level in 1932, and the number
of riots peaked in 1934 at almost twice its normal frequency. Unsurprisingly,
the tendency of governments to resort to violent acts of repression also peaked
during the tumultuous years of the Great Depression, with the frequency of purges
reaching a high of 2.6 times its average level in 1934. Europe and the US
experienced two waves of turmoil and increasing uncertainty. In each case, the
continued existence of the established political and economic order was in
question. Following the end of World War I and the Russian Revolution in 1917,
chaos and civic unrest broke out in numerous countries. After the end of the
Habsburg dynasty and the disintegration of the Austro-Hungarian Empire, a large
number of new nation states was formed. In Germany, the Emperor abdicated;
revolution came when Navy sailors mutinied and widespread strikes broke out. Returning
troops supporting the Social Democratic government were fighting former
comrades who sought to establish a German equivalent to the Soviet Union, led
by two leading communist intellectuals of the day, Rosa Luxembourg and Karl
Liebknecht . Right-wing putsches such as the Kapp Putsch in 1920 and the Hitler
Putsch in 1923 destabilized the new democratic order, already undermined by the
harsh terms of the Versailles treaty. Leading political figures such as
Matthias Erzberger and Walter Rathenau fell victim to political murder. A
Belgian-French invasion of the industrial heartland, the Ruhr, as well as
Communist uprisings in Saxony and Thuringia compounded problems . In the years
1919-23, there were 13 government crises, the same number of riots, and three
general strikes. In France, there were waves of strikes in 1919 and 1920,
considered by some observers as "a concerted attack upon the structure of
bourgeois society". Nonetheless, these attacks ultimately failed -the
trade union activist Merrheim said he "found in France a revolutionary
situation without ... any revolutionary spirit in the working classes" .
In the US and Britain,
demobilizations and the end of war did not lead to the same degree of extreme
instability as in continental Europe. However, the very sharp contractions in
output and employment in 1920/21, engineered in part as an attempt to reduce
prices and return to the gold standard at prewar parities, led to a
considerable rise in worker militancy. This occurred against the background of
a considerable strengthening of organized labor. As in the other belligerent
countries, the position of labor had strengthened as a result of the war effort
- governments recognized unions and encouraged cooperation between them and
employers. Trade union membership in the TUC (Trades Union Congress) soared
from 2.2 million in 1913 to 6.5 million
in 1920. In the data set, Britain
records 39 riots between 1919 and 1922, 12 assassinations, 6 general or
politically motivated strikes, and 5 major government crises over the period.
The average number of days lost in industrial disputes soared from 4.2 million
in 1915-18 to 35.6 million in 1919- 23, the highest recorded value.
Dissatisfaction with the established order could take a number of forms. In the
US, there were 5 assassinations and four general or politically motivated
strikes in 1919-23. Only one riot broke out, but 17 anti-government
demonstrations were recorded. The total number of strikes increased sharply, to
3,630 in 1919, involving 4.2 million workers . Fear of a Communist takeover
took the form of the so-called "Red Scare". Following the founding of
the Third International in March, two Communist parties were formed in 1919,
and quickly became active in propaganda . In response to bombs mailed to
politicians by terrorists, a widespread crack-down, led by the Justice
Department's Radical Division under J. Edgar Hoover, began. The second half of
the 1920s saw a considerable decline in worker militancy and political
violence. The 'roaring twenties' brought prosperity to many countries, with
some exceptions. The US economy expanded rapidly, France reaped the benefits of
currency stabilization under Poincare, and Germany, with the help of foreign
loans, experienced an upsurge in activity after the end of the hyper inflation
. At the same time, Britain's economy - tied to gold at an overvalued exchange
rate - continued to languish . But even in those countries that didn't
experience booms, labor militancy was on the wane. With the exception of the
general strike in Britain in 1926, labor movements created few troubles. The
democracies of central Europe appeared to be stabilizing . Riots declined to
less than one-third their average frequency in the preceding half-decade;
government crises, which had been running at an average of more than 10 per
year in the early 1920s, fell to 3 in 1927, 2 in 1928, and 5 in 1929. The
second wave of unrest and politically motivated violence began in 1930, with
the start of the Great Depression. Over the course of the crisis, industrial
output in the US and Germany fell by 40-50 percent from peak to trough, and
between a quarter and a fifth of all industrial workers were unemployed over
the period 1930-38. In the face of massive capital outflows and pressure on
reserves as a result of banking panics in Germany, Austria and the US, central
banks first tried to defend the gold standard by a policy of deflation .
Eventually, more and more countries abandoned the peg, either by devaluing or
via a system of capital controls. Countries that remained on gold for a long time
experienced the most severe contractions. France, which had initially avoided
problems, eventually experienced major difficulties. Faced with a slump that
extended into the second half of the 1930s, it was eventually forced to devalue
in June 1937. Britain, which was amongst the first to abandon the gold
standard, escaped relatively lightly.'' Recovery came faster and in a more
robust way to the countries that abandoned gold first .
Economic difficulties were
quickly reflected in the politics of the street and the factory floor. The
total number of anti-government demonstrations soared from 22 in 1925-29 to 72
in 1930-34; riots rose from 62 to 108. The number of politically motivated
general strikes increased from 7 to 10. In Germany, there is clear evidence
that high rates of unemployment did much to boost the fortunes of the Communist
party, already one of the strongest in the world . Recent research also
demonstrates that areas in which incomes contracted particularly sharply saw
the largest increase in votes for the Nazis . In Britain, the Bank of England
decided to leave the gold standard instead of raising the (relatively low)
discount rate - a decision that can only be understood as an attempt to avoid
any further rise in unemployment, and the threat of instability that would
follow from it . Apprehensiveness was
accentuated by the mutiny of the Royal Navy in the port of Inverness in 1931.
In the US, the Communist party
expanded rapidly during the Great Depression, and union membership soared. As
"Hoovervilles" spread around American cities, bitterness against the
rich and civic unrest became more widespread. Arthur Schlesinger noted about
the year 1931 that "a malaise was seizing many Americans, a sense at once
depressing and exhilarating, that capitalism itself was finished" . The
Hoover administration - despite its general willingness to balance the budget
by whatever means necessary - opposed a cut in Army infantry units in 1931 because
it would "lessen our means of maintaining domestic peace and order." In a secret message to Congress, the President
urged that troops be exempted from a 10 percent pay cut so that the nation
would not have to rely on disaffected troops in case of internal troubles.
William Z. Foster, one of the most outspoken Communists in the US, published
his book Toward Soviet America in 1932. The party found rich grounds for its
agitation amongst the millions of unemployed and impoverished . In the same
year, the so-called Bonus Army marched on Washington - veterans demanding that
their bonuses be paid ahead of time. It took cavalry, infantry and tanks,
commanded by General Douglas MacArthur, to regain control .
Perhaps even more importantly,
the crisis rapidly increased the chances of Franklin D. Roosevelt gaining office.
While even the most conservative businessmen did not equate this with a
communist take-over, worries about the continued existence of "capitalism
as we know it" were
rampant. As Schlesinger noted,
the "New York governor was the only presidential candidate in either major
party who consistently criticized business leadership, who demanded drastic (if
unspecified) changes in the economic system, who called for bold
experimentation and comprehensive planning." Worries about future economic policy was compounded
by the increasing realization that a return to the so-called "New
Era" of prosperity and growth was impossible. Faced with growing labor
militancy and an increasing willingness to contemplate central planning among
the mainstream parties, right-wing radicalism also began to gain a following.
Some observers and politicians, including prominent US senators, began to call
for a Mussolini-style government, and magazines such as Vanity Fair and Liberty
argued the case for a dictatorship .(Voth,2002)
This paper provides a systematic approach to evaluate the impact
of political elections on currency values and market volatility across 22
countries. We have found that there is a significant relationship between
political uncertainty and financial crises after controlling for market
contagion and differences in economic conditions. We have also discovered
increased market volatility during political election and transition periods.
We further confirmed the result of Radelet and Sachs (1998) that the defining
element of financial crises is the vulnerability to panic, as measured by high
levels of short-term debt to reserves. Another important
predictor of crisis is the rapid buildup of bank claims.
Our results about political risk have a few interesting practical
applications: First, our analysis suggests that emerging market governments
should increase their vigilance against financial crisis during political
election and transition periods.23 Second, investors should note that the odds
of financial crisis tend to be much larger during the political election
periods. Thus, proper protection or risk adjustment needs to be taken when
making emerging market investment during those time periods. It is worth
noting, however, political election does not necessarily lead to financial
crisis.24 Thus, we would like to caution against using the result as a simple
“sure-win” investment strategy. Third, the pricing of emerging market
derivatives should not be based on assumption of constant market volatility. As
a matter of fact, market volatility tends to be much higher during political
election and transition periods.(Mei and Guo,2002)
(Zahid
and Rajaguru,2010) paper investigated the impact of internal and external
shocks on financial market whichcan affect the macroeconomic performance.
Pakistan experienced major international and domestic political shocks during
the decade starting May 1998 and thus makes it an interesting choice for such
an analysis. An autonomy of the historical events unfolded in
Pakistan
from 1999-2008 suggests that even the external shocks were the results of
certain
policies
of the ruling regime. We term these shocks as events and use Markov switching
process
to perform an event analysis. The paper first lists a number of events unfolded
during
the period under analysis using a variety of internet and published sources and
then
identifies
the nature and expected impact of these shocks based on a survey results.
Finally,
empirical
estimation is performed to determine the number of regime changes and the
impact
of
shocks on the currency market. Later, Granger causality within Markov switching
VAR
framework
is used to find evidence of financial market interlinkages. The shocks can
affect
the
macroeconomic performance through spillover effects from one sector of
financial market
to
another.
The
empirical evidence of this paper suggests 2 regime changes with low and high
volatile
periods
in Pakistan during the period under analysis. The results show that the
financial
market
is expected to move between two regimes where the mean and variances are
different
in
each state. The empirical results are, in general, consistent with the
expectations obtained
through
of the survey methods. The political events are expected to have positive or
negative
impact
on the financial market consistent with the nature of shocks.
Finally,
the empirical evidence on the market interlinkages supports the view that all
three
markets
under the broad category of financial market in Pakistan are closely
interlinked. As
such,
any shock that disturbs the currency market will have spillover effects on the
stock and
money
markets thus leading to slow down of the economy. These are interesting results
and
have
important policy implications. The findings of this paper suggest that regimes
should be
mindful
of an extreme political decision. Measures such as a reduction in fiscal
spending (or
cutting
budget deficits) and less reliance on external borrowing will help reduce country’s
exposure to
shocks and her capability to absorb them.
REFERENCES
Corredi,Valentina,Walter
Distaso and Antonio Male,2010,Macroeconomic Determinants of stock market
volatility and volatility risk premium-London School of Economics.
Khalid,A.M.,and
Gulassekaran Rajaguru,2010,The impact of Political events on Financial Market
volatility using a Markov switching process.Bond University,WP no-43.
Mei,Jianping
and LiminGuo,2002,Political uncertainty Financial crisis and Market volatility,
NewYork University.
Voth,Hans-Joachim,2002,Why was stock market
volatility so high during the great depression? Evidence from 10 countries
during the interwar period.MIT,WP-02/09
