What Sets the Volatility of Markets?

What Sets the Volatility of Markets?

Trading & Investing
Crowd gathering on Wall Street the day after the 1929 crash.

The efficient market answer is “the volatility of fundamentals, itself driven by the flow of un-anticipated news”.

The order-flow driven view of markets (aka inelastic market hypothesis), on the other hand, asserts that volatility mostly reflects flow imbalance and intensity, whether these flows are informed or not. My postulate is that the most important factor affecting market participants’ beliefs and anticipations is the past trajectory of price itself.

And indeed, it has been known for quite a while that past price drops lead to increased future volatility. However, in this case, one can actually come up with an efficient market story. As Fisher Black did when he dubbed this the “leverage effect”. There are however many reasons to believe leverage is not a very plausible determinant of the observed effect.

However, there is a more striking effect that is hard to fathom within the efficient market framework: price *trends*, either up or down, also lead to higher future volatility.

This effect was first pointed out by Gilles Zumbach, and has inspired several recent models, including our own “Quadratic Hawkes” model, where past trends increase the future rate of market orders and cancellations, leading to higher volatility and, possibly, liquidity crises and endogenous price jumps.

In a recent fascinating paper that builds on these ideas. Julien Guyon and Jordan Lekeufack propose a model where volatility is almost *entirely* explained by the past price path. Which means that there is little need to add an additional, truly stochastic component to account for the dynamics of volatility.  

Volatility Is (Mostly) Path-Dependent by Julien Guyon, Jordan Lekeufack :: SSRN
stockbrokers working at the New York Stock Exchange, 26 September 1963

Although one might quibble a bit about their conclusion, I think this is a very important result.

Firstly, it shows that the popular “local volatility” model, which posits that volatility depends on the current price level and not the past history of that price. However, we find this completely misguided. And in fact leads to erroneous conclusions concerning, e.g. the dynamics of option smiles.

Secondly, it reinforces the view that market volatility is mostly endogenous and has little to do with fundamentals – as anticipated long ago by Rob Shiller and in accordance with the intuition of anyone who has looked at how markets really work.

Written by Jean-Philippe Bouchaud 

A French physicist, co-founder and Chairman of Capital Fund Management (CFM), adjunct professor at École Normale Supérieure and co-director of the CFM-Imperial Institute of Quantitative Finance at Imperial College London. Furthermore, he is a member of the French Academy of Sciences. In addition, held the Bettencourt Innovation Chair at Collège de France in 2020.


What Sets the Volatility of Markets?
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What Sets the Volatility of Markets?

Trading & Investing