Maneesh Deshpande from Barclays and Tim Edwards from S&P Dow Jones Indices combined forces to deliver a presentation titled Impact of Flows on Cash and Derivatives Markets: Myths and Realities. I’ve always been a sucker for presentations that use the phrase Myths and Realities and this part of RMC lived up to my expectations.
Deshpande started out talking about the impact of flows on the equity markets. With respect to volatility target funds he stated that they are targeting a level of portfolio volatility and that since forecasted volatility increases as equities sell off a sell off may be exacerbated if these funds need to unload stocks. Then he discussed risk parity funds noting that about $175 billion in assets is allocated to risk parity oriented strategies. Since equity risk dominates the balance in a risk parity strategy, when stocks sell off it is possible managers would need to sell stocks. Finally, he addressed an option expiration anomaly associated with third Friday SPX options. He noted that expiration to expiration volatility is consistently higher than month-end to month-end volatility.
Deshpande also addressed three issues associated with the impact of flows on equity derivative markets. He noted the impact of flows in VIX ETPs and reminded everyone that the assets under management in VIX related ETPs reached new highs in 2016. With respect to the impact on the market that the VIX futures market have absorbed the inflows better than they did in 2012. He also discussed the impact of buy-write funds which can be classified as a myth. The common belief is that volatility selling by buy-write funds has dampened volatility. However he noted that buy-write funds has actually experienced a net outflow of funds since 2013. Finally he posed the question, “Are volatility selling strategies suppressing volatility?” He states that volatility is low, but there has not been excessive selling of volatility to push it lower. Finally, Maneesh made the comment that we should not think there is a conspiracy to keep volatility low.
Tim Edwards took over and started out talking about the difficulty of measuring liquidity unless you actually place a trade. Edwards notes that a decent model of liquidity should accommodate four observations: trading costs for execution of trades up to fairly large size tend to rise in proportion to square root volume (think non-linear relationships), special exception may need to be made for very large trades, fixed a security and time period, observed price changes tend to scale in proportion to observed volumes, and when measured over increasingly long intervals, observed price volatility tends to scale in proportion to the square-root of observed volumes.
Edwards went on to discuss common academic and professional approaches to measuring trading impact costs or liquidity. He concluded noting that liquidity is difficult to track, but not it is possible to measure liquidity and market impact. Finally he noted that day to day, volatility expectations are the most significant component of liquidity. Over long periods, volumes do change such as the rising liquidity in ETF and futures have had an observable impact.