Published as part of the Financial Stability Review, May 2024.
Implied equity market volatility has been low in recent years, in both absolute and relative terms. Abstracting from short-lived spikes, implied equity market volatility has broadly declined since March 2020, despite tighter monetary policy, rising geopolitical tensions and a balance of risks to economic growth tilted to the downside. At the current juncture, low implied volatility in equity markets contrasts with signals from some leading economic indicators (Chart A, panel a) and still-elevated implied volatility in interest rate markets; the ratio of the two is at the lowest level in decades for both the United States and the euro area (Chart A, panel b). In addition, the subdued volatility skewness in the equity markets points to benign pricing of the downside risks (Chart A, panel c). This box discusses factors behind low levels of implied equity market volatility, its divergence from the implied volatility in interest rate markets and possible implications for financial stability, including underestimation of risks and related to this excessive risk-taking.
Chart A
Implied equity market volatility seems subdued but, as in the past, it might rise quickly
a) Historical distribution of implied volatility in equity markets in periods of expected economic growth or contraction proxied by leading economic indicators | b) Implied volatility in equity markets relative to interest rate markets | c) Implied volatility skewness in equity markets |
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(Jan. 2000-Apr. 2024, percentage points) | (Jan. 2000-Apr. 2024, ratio) | (Jan. 2007-Apr. 2024, percentage points) |
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Sources: Bloomberg Finance L.P. and ECB calculations.
Notes: Panel a: based on the Conference Board Leading Economic Indicators, with positive year-onr-year change indicating growth. The whiskers correspond to the minimum and maximum of monthly average values of equity market implied volatility (euro area – VSTOXX, United States – VIX). Panel b: ratio of equity market implied volatility (VSTOXX – euro area, VIX – United States) to interest rate market implied volatility (euro area – SMOVE, United States – MOVE). Panel c: difference between implied volatility in 5% delta put and 5% delta call one-month options on the EURO STOXX 50 (euro area) and the S&P 500 (United States).
Several factors may have contributed to the low levels of implied equity market volatility. During the period of relatively high inflation since 2021, diversified equity portfolios might have been seen as offering better inflation protection than fixed-coupon bonds, as nominal corporate earnings, from which equities pay a dividend, tend to grow with the price level. More recently, progress in bringing down inflation without a deep economic contraction has fostered investor optimism. This has been reflected in a sustained period of rising equity prices and declining realised volatility, which comoves strongly with implied volatility. While broader risks to the economic outlook prevail, lower implied equity market volatility may have also been supported by declining uncertainty regarding the growth outlook, visible, for example, in analyst expectations (Chart B, panel a). In addition, investors might expect that low correlations across stock returns could prevail and further contribute to low volatility at index level (Chart B, panel b).[1] Subdued demand for tail-risk protection could be another potential explanatory factor. Investors might assume that major central banks now have more scope to ease monetary policy in response to financial stability risks than they did at the onset of the inflation surge. This may have led to expectations – which might not necessarily hold – that despite elevated tail risks, their materialisation would only lead to a transitory period of higher equity price volatility.
Chart B
Progress towards a soft landing and low correlations across individual stocks supported VIX decline
a) Standard deviation of real GDP growth expectations and implied volatility in the US equity market | b) Implied broad market volatility and implied correlations between individual stocks in the US equity market | c) Spread between implied and subsequent realised equity market volatility |
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(Jan. 2015-Apr. 2024, percentage points) | (2 Jan. 2017-7 May 2024, percentage points) | (Jan. 2017-Apr. 2024, percentage points) |
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Sources: Bloomberg Finance L.P., Consensus Economics Inc. and ECB calculations.
Notes: “COVID-19 turmoil” refers to the pandemic-related market crash that occurred between 21 February and 16 March 2020; “Volmageddon” refers to the period from 1 to 5 February 2018, when stress in the US equity market was induced by forced unwinding of outsized short volatility positions.* Panel a: standard deviation of analysts’ one-year-ahead real GDP growth expectations. Panel b: “Implied correlation”, as measured by the Cboe Implied Correlation Index, captures the average expected correlation between the top 50 stocks in the S&P 500 index. Solid black fitted line is an exponential function. Panel c: spread between 30-day implied volatility (euro area – VSTOXX, United States – VIX) and subsequently realised 30-day volatility of underlying indices (euro area – EURO STOXX 50, United States – S&P 500).
*) See Augustin, P., Cheng, I. and Van den Bergen, L., “Volmageddon and the Failure of Short Volatility Products”, Financial Analyst Journal, Vol. 77, No 3, 2021.
Increasingly common short volatility strategies may also have suppressed implied equity market volatility and increased the risk of sudden repricing. These strategies aim to profit from declining or low equity volatility by selling equity options or taking short positions on VIX-based derivatives. Most of the time, they provide positive returns thanks to positive volatility risk premia – the difference between implied and subsequently realised volatility (Chart B, panel c) – but suffer large losses when there are spikes in volatility. Substantial profits from such strategies in recent years have increased interest in deploying them, thus potentially contributing to the downward trend in the VIX.[2] In addition, there has been growing interest in trading options on the day of their expiry (“0 days to expiry” or “0DTE”), potentially also among “short volatility” traders.[3] In view of the increasingly crowded positions in such trades, their abrupt unwinding − triggered for example by a tail event − could lead to a disorderly correction and volatility feedback loops, as was the case during the “Volmageddon” volatility spike of February 2018 which led to large losses on short volatility strategies. The historically high end-of-day exposures to broad US equity market volatility instruments (Chart C, panel a), as well as an intraday build-up of positions in 0DTE options, could make such market adjustments less orderly.[4]
Chart C
While positions in equity volatility instruments accumulate, high implied volatility in interest rate markets points to downside risks to GDP and equity prices
a) Open interest in US broad equity market volatility instruments | b) One-year ahead distribution of US and euro area GDP growth with and without conditioning on current high implied interest rate market volatility | c) Response of US and euro area equity prices to a global risk-off shock |
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(Jan. 2007-Apr. 2024, millions) | (Apr. 2024, percentage change per annum) | (1 Sep. 2005-26 Apr. 2024, percentage changes) |
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Sources: Bloomberg Finance L.P., ECB, LSEG and ECB calculations.
Notes: Panel a: open interest in S&P 500 options also includes options on the S&P 500 mini, S&P 500 nano and SPDR S&P 500 ETF, all adjusted to reflect the same notional. Open interest in VIX futures and options also includes mini VIX futures, adjusted to reflect the same notional. Panel b: predicted quantiles of year-on-year GDP growth distribution one year ahead as of April 2024, estimated with quantile regressions using a set of explanatory variables from January 1989 (January 1999 for the euro area) to April 2024, with and without implied interest rate market volatility (United States – MOVE, euro area – SMOVE). For both the euro area and the US, the lower 10th percentile (not shown in the chart) is estimated to be lower when the MOVE/SMOVE is included. Panel c: the dots represent the mean estimate of the response of US and euro area equity prices to a global risk-off shock. The shock is identified in a daily Bayesian vector autoregression (BVAR) model by Brandt et al.* and calibrated to a flight-to-safety impact of around -10 basis points on the ten-year US Treasury yield. Impulse responses are shown after one week and are estimated by local projections allowing for state dependence, similar to the approach in Ramey and Zubairy**, with the gamma parameter assumed to be 2. The estimation controls for economic activity, interest rates, funding conditions and stock market uncertainty in the United States and the euro area respectively (measured by the Citigroup Economic Surprise Index, the spread between the ten-year and the two-year bond yield, financial conditions index and the stock market implied volatility) and includes a crisis dummy for the weeks of the peak of the global financial crisis and COVID-19 turmoil. The states are defined based on the US and euro area interest rate market uncertainty, as measured by the MOVE and SMOVE respectively.
*) Brandt, L., Saint Guilhem, A., Schröder, M. and Van Robays, I., “What drives euro area financial market developments? The role of US spillovers and global risk”, Working Paper Series, No 2560, ECB, 2021.
**) Ramey, V.A. and Zubairy, S., “Government Spending Multipliers in Good Times and in Bad: Evidence from US Historical Data”, Journal of Political Economy, Vol. 126, No 2, 2018, pp. 850-901.
Elevated implied interest rate market volatility could point to downside macro-financial risks that equity investors do not seem to have fully priced in. Risks surrounding the economic outlook and the related monetary policy response remain elevated, against the background of rising geopolitical risks. These factors explain why implied interest rate market volatility is elevated and, in contrast to low option-implied equity market volatility, might signal prevailing financial stability risks. Historically, elevated implied interest rate volatility has been associated with larger downside risks to economic growth around one year ahead in particular (Chart C, panel b).[5] Empirical evidence also suggests that equity prices tend to respond more strongly to global risk-off shocks when implied interest rate volatility is elevated (Chart C, panel c). This implies that equity prices could be particularly vulnerable to shifts in risk appetite or other adverse shocks in the current environment of elevated implied interest rate volatility.
Low implied equity market volatility could mask financial stability vulnerabilities. Low realised and implied volatility in financial markets can support financial stability to the extent that it properly reflects sound fundamentals and a stable risk outlook. However, subdued implied equity market volatility – despite broader uncertainties related to the macroeconomic outlook and heightened geopolitical risks, as reflected in elevated implied interest rate volatility – might suggest an underestimation of risks in equity markets and excessive risk-taking.[6] Consequently, adverse economic surprises or geopolitical shocks could lead to significant market corrections. Large exposures in volatility instruments could, in turn, increase the likelihood of a disorderly correction.
When correlations across individual share prices are low, more diverse changes within the stock price index tend to cancel out and the overall index performance is more stable.
Investment funds that add a “short volatility” component to their broad market exposure, when pursuing a “covered call” strategy for instance, have experienced substantial inflows over the last two years. Their selling activity might put downward pressure on the prices of options used to calculate the VIX. See also Todorov, K. and Volkov, G., “What could explain the recent drop in VIX?”, BIS Quarterly Review, Bank for International Settlements, March 2024, pp. 6-7.
While outsized supply of 0DTE options does not affect the VIX directly, it might have some dampening impact on its level if, for instance, market-makers decide to proxy-hedge their positions with longer-dated options or due to the deployment of specific term spread strategies.
For a more detailed discussion on risks from 0DTE options, see, for example, the box entitled “The risks from hidden leverage in short-term equity options”, Financial Stability Review, ECB, November 2023.
A similar argument is made by Sarisoy, C., “Elevated Option-Implied Interest Rate Volatility and Downside Risks to Economic Activity”, FEDS Notes, Board of Governors of the Federal Reserve System, 22 December 2023.
See also, for example, “The Volatility Paradox: Tranquil Markets May Harbor Hidden Risks”, Markets Monitor, Second Quarter 2017, Office of Financial Research, 2017.