Peak in volatility causes decrease in asset prices

The importance of understanding the decline

In just a few weeks, worldwide stock indices have fallen by more than ten percent, while at the same time uncertainty has increased. The current decline in the share price, the uncertainty about future share price movements, but also the expected recovery, have significant social consequences, for example for the financing of new investments or for the indexation of pensions. It is therefore very important to gain a better understanding of the background to these extreme drops in share prices, says Lange. In his research, he shows that the market return on equities is highly predictable and that the fall in share prices is expected to be temporary.

A stationary process

Uncertainty about future price movements is measured on the basis of volatility (VIX). Outliers in this volatility are always short-lived; within three months to a year, the squared VIX returns to an 'idle state' of one percent. The process is stationary with short periods of temporary outliers upwards, followed by a recovery to the same idle state.

Risk-return balance

Financial markets are characterised by a trade-off between risk and return: the higher the risk, the higher the expected return. An increase in the VIX means that the market expects share prices to be more volatile than usual in the upcoming month. This relationship implies that with a higher VIX, the return on shares must also be higher. If that is not the case, a rational investor would switch to other investments with a better balance between risk and return. According to Rutger-Jan Lange, investors can achieve an above-average return on equities in the coming months, but this return can only be achieved if investors are also willing to take more risk.