Coping with Global Volatility

April 15 - 16, 1999

The last Financial Markets Research Center conference of the millennium, held on April 15th and 16th, focused on the topic, "Coping with Global Volatility,” a subject reflecting the significant volatility of the prior year. Emerging markets faced major difficulties in recovering from banking and exchange rate crises; Europe and the Euro headed into uncharted territory; and the near demise of Long Term Capital Management disrupted U.S. financial markets. While U.S. equities markets recovered relatively unscathed, foreign markets and fixed income markets continued to feel the aftershocks of the financial markets disruptions. The conference offered insights into the sources and effects of volatility and the appropriate response of investors and regulators. 

The conference was sponsored by the Financial Markets Research Center, and by a generous grant from the New York Stock Exchange.

The conference began with a presentation by Peter Fisher, Executive Vice President of the Federal Reserve Bank of New York, whose good offices helped resolve the LTCM crisis of the preceding September. Fisher cautioned that regulatory intervention in financial markets should be limited, noting that volatility could be a sign of either sickness or health.  The role of the Federal Reserve Bank as regulator was to make markets boring, while recognizing that prices need to adjust to equilibrium levels without interference.  In his view, the volatility in Southeast Asia reflected an absence of risk management systems.  He concluded his remarks by emphasizing the need of executives to adopt incentive systems that reward reasonable risk taking but penalize excessive risk taking.

The first session, "Equity Volatility," was chaired by Peter Layton, a partner with long-time center member Hull Trading.  In the first presentation, Robert Whaley of Duke University discussed whether the Black-Scholes model could be improved by modeling volatility as a deterministic function of asset price and time to maturity. In a paper co-authored with Bernard Dumas of INSEAD and Jeff Fleming of Rice, he finds that such a modification does well in-sample, but performs poorly out-of-sample with regard to both valuation and hedging.  William Speth, Director of Research at the Chicago Board Options Exchange offered a commentary on volatility and the option market.  He noted that both implied and realized volatility have remained at historically high levels the past three years.  Speth attributed this pattern to the popularity of technology stocks, and their increased presence in indexes. Speth concluded by noting that the best way for the CBOE to cope with volatility is by remaining open, and he applauded the relaxation of collars and circuit breakers. Jose Marques, Director of Equity Research at Hull Equity Management, echoed the sentiment that volatility had risen dramatically, and commented that the frequency of 2% moves in the S&P 500 increased by a factor of more than 7 over the past year.  More important, he stated that February and March of 1999 witnessed a startling increase in long-term implied volatility that might reflect the markets expectation of a large correction.  He concluded that the repercussions from the past year’s volatility may still be working their way through financial markets.

The second session, “Fixed Income Volatility," was chaired by Roger Huang, Professor at the Owen School and Associate Director of the FMRC.  Cliff Ball, Associate Professor at Owen, presented his paper "The stochastic volatility of short term interest rates: Some international evidence,” co-authored with Walter Torous at UCLA.  Ball's work deals with the same issue raised by Whaley – how best to model volatility -- but looks at stochastic rather than deterministic volatility models.  He noted that volatility of interest rates is less persistent than stock return volatility and that reversion to the mean volatility was more rapid in fixed income markets.  Louis Scott, Vice President of Fixed Income Markets at Morgan Stanley Dean Witter, provided the final commentary of the morning.  Scott provided a practitioner’s perspective on interest rate volatility, and suggested that studies of fixed income markets should focus on longer maturities since the one-month Treasuries are among the least active products.

After enjoying lunch and informal discussion at the University Club, the afternoon resumed with a session on "Europe and the Euro,” chaired by David Brunner, President of Paribas Corporation. Brunner highlighted numerous reasons why the skeptics of an eventual economic union were wrong, chief among which was the underestimation of political will.  He also stressed the benefits to such a union, including the reduction in inflation, interest rates and deficits, and the elimination of foreign exchange risk.  His remarks were followed by those of Geert Rouwenhorst from Yale, who presented his paper "European equity markets and EMU: Are the differences between countries slowly disappearing?" Rouwenhorst showed that while both industry and country effects are important in describing differences in returns across markets, country effects continue to be dominant despite the apparent integration of Europe.  He offered several explanations, including the home country bias, monetary shocks and local economic shocks.  Brian Fabbri, Chief Economist North America with Banque Paribas, provided the commentary. Fabbri provided an upbeat prognosis for the Euro, fueled by a predicted increase in GDP and lower inflation.  European investors will no longer be constrained to investing in specific countries, and the Euro market is expected to constitute 35% of global bond indices.

The final session of the day, "Emerging Markets," was chaired by George Sofianos, Managing Director of the New York Stock Exchange.  Laura Kodres of the International Monetary Fund presented the first paper of the session "A rational expectations model of financial contagion" which was co-authored with Matt Pritsker of the Federal Reserve Board.  Kodras noted that financial shocks in one country can be transmitted to other markets for various reasons – because information shocks are correlated, because  liquidity needs spill over, because of cross-market feedback trading, and because of cross-market portfolio balancing.  Kodres and Pritzker emphasize the contagion that results as the hedging of risks in one country transmits those risks to another country. Simean Djankov, Financial Economist with the World Bank, presented the paper "Corporate governance and risks in emerging markets: Evidence from East Asia," co-authored with Stijn Claessens, Principal Economist with the Financial Economics Group and Larry Lang, visiting at the University of Chicago.  Djankov noted that the failure of risk management systems was particularly evident in East Asia.  The lack of transparency in the reporting systems resulted in high levels of information asymmetry.  He cautioned that the specific governance structure wasn't as important as understanding who controlled the operations, and suggested that the answer lay in "following the money!"  The session concluded with two industry commentaries.  The first was provided by Dick McDonald, Economist with the Chicago Mercantile Exchange, who described the chronology of the collapse of the Russian ruble, which was reflected in the ruble futures and options contracts traded on the CME. Futures and options trading of the ruble ceased when Russia defaulted on its debt on August 17, 1998.  The second commentator was Amy Falls, Head Analyst for Emerging Markets at Morgan Stanley Dean Witter. She spoke on the relation between volatility and reductions in capital flows, and argued that liquidity was a greater factor than solvency in explaining contagion.

The meeting was then adjourned for the day, and the group re-assembled for dinner and conversation at the Vanderbilt Plaza Hotel. On Friday morning the conference relocated from the University Club to the newly renovated Executive MBA classroom at the Owen School.  

The first session of the day, "Risk Management," was chaired by Jeffrey Davis, Chief Investment Officer, Fundamental Strategies, State Street Global Advisors.  Michel Crouhy, Senior Vice President of the Canadian Imperial Bank of Commerce, began the session with his presentation "Price risk: There is no ‘holy grail’, but don't bash VaR yet".  Crouhy discussed how CIBC identifies, measures and manages credit risk, and explained the advantages/disadvantages of various modeling approaches. In particular, he noted the need to integrate the modeling of credit and market risk. Paul Kupiec, Principal Economist with Freddie Mac, presented the paper “Risk capital and VaR”.  Kupiec places VaR in the context of capital structure, and highlighted the importance of incorporating required interest payments on long-run debt. Clinton Lively, Managing Director of Global Risk Management for Bankers Trust, provided the final commentary of the session.  Lively underscored the importance of VaR as a disciplined framework for understanding risk management.  He noted that model validation requires constant measurement of whether replicating portfolio's neutralize gains and losses through time, and that a traders skill can overcome model inadequacies.

The final session of the conference, "Regulatory Issues,” chaired by Hans Stoll, Owen Professor and Director of the Financial Markets Research Center, offered a panel of experts the opportunity to express their views on the realities of regulation.  John Damgard, President of the Futures Industry Association, commented that the futures industry is becoming a global enterprise, something that presents tremendous regulatory challenges.  The competitive landscape is also shifting rapidly, as, among other things, Nasdaq is considering an electronic futures exchange and the CME is contemplating becoming a for-profit entity. Damgard noted that OTC derivatives are best left outside the jurisdiction of the CFTC but expressed the concern of organized futures markets that must compete against less regulated markets.  The second panelist, Rick Kilcollin, former President of the Chicago Mercantile Exchange, commented on the movement towards competition and deregulation, as evidenced by the convergence of the banking and securities firms, and by the advent of technologies that change the way business is transacted.  The increase in electronic communication networks (ECN) has led the SEC to question the meaning of an exchange.  He noted that the advantage of avoiding the exchange designation is that the market center avoids excessive regulation, but losses the ability to charge for its quotes.  In the end, Kilcollin predicted even greater levels of competition, as evidenced by the NYSE's move to trade Nasdaq stocks through their own ECN.  The final panelist was Pat Parkinson, Associate Director in the Division of Research and Statistics at the Federal Reserve Board. Parkinson directed his comments to the OTC market, and outlined the pros and cons of regulating derivative dealers, as well as the OTC exchanges and clearing houses.  He espoused the role of regulation in both deterring fraud and providing for protection against losses stemming from systematic risk, yet he emphasized the importance of freely functioning markets.