Doug's query on volatility

Greg Nowell GN842 at CNSVAX.Albany.Edu
Sat Apr 10 11:40:47 PDT 1999

I find myself increasingly agnostic on this. It seems to me that the "war on volatility" (if there ever is to be one would have to focus on two issues.

1. Crises which depress financial assets to the point that lending and real investment are affected. We had a near shutdown of the high grade junk bond market (which is real investment, at least some of it) following the stock market meltdown of August. Obviously "volatility" which is unidirectionally up does not have this effect. The point of worrying about too much up is that it might generate too much down, strainging liquidity even if the Fed chooses to intervene. The junk bond market took a long time to respond to the Fed's increase of liquidity and still hasn't recovered, in point of fact. One way of looking at this is that investors are demanding a higher premium to be in higher default risk instruments. This means "uncertainty" is taking a toll on total potential productivity (which is pretty good notwithstanding, but tyou get the idea).

Consider the following two series (as measures of stock value for example):

10 11 9 8 9 11 9 versus

10 11 10 11 5 11 11 Note that we have more "routine volatility" in the first series but we have a "calamitous dip" in the second series. It seems to me that the calamitous dip is the kind of volatility that takes a huge toll on output, scares investors, and makes them demand a protection premium. One of the things I'm not sure about is whether a modest measure such as a Tobin tax, whch may or may not reduce volatiltiy in the top series, would have any effect on the important case of the calamitous dip in the second series.

2. While it is true that stock market volatility has nothing to do with corporate finance per se, stock market gyrations do have a fairly consistent impact on the low grade high risk bond world (which is not exclusively leveraged buyouts) which finances a good deal of "real investment". Via this route I would suggest that the stock market may impinge on the whole spread of lending activity, which makes it important regardless of whether stocks are directly used to raise cash. Moreover, stock market fluctuations do have an impact on the demand for credit via margin calls and such, and stock portfolios also affect calculations of net worth used to calculate loan eligibility for both business and private borrowing. (At any rate I was certainly asked to produce certificates and statements when I take out a mortgage, which I've odne three times, each time filling out a sheet called statement of net worth in which assets and liabilities are cataloged and supporting documentation supplied.) This would be in addition to the effect the market value of stocks has on personal estiomates of worth and consumption behavior.

To the extent that any of these things are affected by stock values we might be interested, as Keynes suggests, in a more low-volatility world than a high one.

As for how to calculate such volatility, that seems to me problematic, becuase the issue is not what *is in fact* "most volatile" by some mathematical definition but what is perceived to be dangerous volatility by investors of whatever stripe.

3. Let me also point out that hte portfolio of outstanding debt will be affected by a firm's valuation. If GE stocks fell by 50% I have a hard time belieiving that it would not affect the liquidity and real interest rate demanded for the GE long bond.

4. Finally, let me say that there is a very thorny issue in the assessment of a "volatility impact." To the extent that volatility is causing investors to prefer short term instruments such as cash and cash substitutes, it becomes one factor in the estimation of the value of debt instruments generally. But volatilty is added to an already complex universe that includes an estimate of the borrower's worth and prospects, the size of the loan, general economic outlook, and so on. While I am sure that econometricians somewhere can try to isolate the impact of the different relevant variables, I'm less certain that, short of a meltdown that causes a national banking system to shut down, we have any tangible estimate of how much "volatility premia" demanded by lenders throttles back real output. This raises the possibility that a transaction tax on speculative maneuvers might have a beneficial impact that we wouldn't see, or contrarily, to believe the detractors, a negative impact that we wouldn't see, either.

-- Gregory P. Nowell Associate Professor Department of Political Science, Milne 100 State University of New York 135 Western Ave. Albany, New York 12222

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