from Liberty Street Economics
— this post authored by David Lucca, Daniel Roberts, and Peter Van Tassel
In recent months, some analysts and policymakers have raised concerns about the unusually low level of stock market volatility. For example, in the June Federal Open Market Committee (FOMC) minutes “a few participants expressed concern that subdued market volatility, coupled with a low equity premium, could lead to a buildup of risks to financial stability.”
In this post, we review this concern and find the evidence of investor complacency is mixed. On one hand, we present a view suggesting that historical volatility may have been abnormally high, rather than current volatility being abnormally low. On the other hand, we find that estimates of the volatility risk premium are somewhat low, which is consistent with the view that investor risk tolerance has increased. We extend this analysis in a related post publishing on Wednesday.
The Low Volatility Puzzle
Common View: Today Is Abnormal and Current Stock Market Volatility Is a Concern
Aside from the FOMC minutes excerpt above, other commentators (for example, see Jeffrey Frankel's recent blog post) have raised concerns about the low level of stock market volatility, especially given the low level of interest rates, which many associate with investors' increased willingness to take on risk (or reach for yield). Based on similarities to the low volatility environment before the financial crisis, some suggest that investor complacency may contribute to a major correction in equity markets when volatility returns to a “normal” level.
