Volatility Is Risk

Abstract

The observation of a stronger noise or a higher volatility in financial markets is usually interpreted as a situation with a higher implied risk profile and vice versa. It is argued here that this is an idea that should be forgotten. When investors enter a market because of the prospect of higher returns, they start buying because the price goes up. This sets off a feedback mechanism causing the price to spiral even higher. This is what we call a financial bubble. The reverse situation, when investors sell because the price goes down, is a crash. Many studies have shown that an asset’s volatility is negatively correlated with its return. This is called “the leverage effect.” As a consequence, volatility may be the lowest at the crest of a bubble, when the price but also the risk has spiralled the highest. Alternatively, volatility may be the highest at the trough of the crash, when the opportunity is the highest.