Japan and the Euphoric Volatility Trap – 3 June 2013

When equity markets are buoyant and optimism abounds, fears of volatility tend to subside. But recent events in Japan remind us that euphoria itself can generate turbulence.

Most people associate rising volatility with bearish market environments. In down markets, mounting fears of further declines often prompt demand for put options, which protect against price declines. This demand causes the price of puts to rise and implied volatilities to increase. Here, the increase in volatility is due to fears of the downside, known in industry jargon as left-tail risk. Think of it asĀ pessimistic volatility.

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