Another Clue to Volatility

Financial economists treat volatility as a function of investors’ responses to new information. They generally presume that if an asset class is more volatile in one geographical region than in another, it is attributable to a difference in either the local version of the asset class or the economic environment. A case study involving high-yield bond volatility in Europe and the United States suggests that cultural differences may also contribute to disparities in volatility.Despite considerable stabilization of financial markets since the recent financial crisis, volatility remains a major worry of investors. Particularly troubling is the absence of satisfactory explanations for cases of extreme volatility. A prime example is the Dow Jones Industrial Average’s sudden 700-point drop on 6 May 2010. More than a dozen instances of mysterious plunges in individual stocks have occurred, including a decline of nearly 90 percent in the price of North Carolina electric utility Progress Energy in a matter of seconds on 27 September 2010.Undeterred by the incomplete understanding of the causes of volatility, market participants expend considerable energy in efforts to avoid or control it. Investors diversify their portfolios and pay premium prices for assets that deliver steady returns. Public companies try to avert big price swings in their shares, using strategies that make good business sense as well as aggressive interpretations of accounting rules that enable them to report unrealistically stable earnings growth. Consultants evaluate money managers on the basis of measures of return versus variance, and the managers, in turn, gear their investment processes toward scoring well on such measures. Some managers cross the line in their attempts to demonstrate high yet stable returns, as demonstrated most dramatically by Bernard Madoff’s unparalleled Ponzi scheme. Finally, regulators consider containing volatility to be part of their natural mandate. Their attempted solutions, which include circuit breakers and short-selling restrictions, have not always had salutary results.Basic analytical tools, including bond duration and earnings per share variability, shed some light on the sources of volatility. Environmental factors, such as the amplitude of business cycles, demonstrably play a role. In such constructs as the capital asset pricing model and arbitrage pricing theory, changes in objective information regarding such factors drive price movements and hence volatility. Empirical research in behavioral finance, however, has found greater volatility than information-based models predict. Behaviorists have developed a keen interest in neuroscience, linking investors’ overreactions to the evolution of the human brain.Both the classical models based on a rational Homo economicus and behavioral models claim universality. Wherever in the world investors may be based, they are operating with brains of the same basic design. It would seem to follow that interregional differences in the volatility of an asset class must reflect differences in either the local variants of the asset class or the investment setting rather than differences among the investors’ thought processes.This inference is challenged by a case study involving the statistically significant difference in volatility between the European and U.S. high-yield bond markets. The researchers rejected several explanations typically offered by market participants. These included differences in interest rate sensitivity, quality mix, concentration in “fallen angels,” number of issues in the index, average issue size, degree of issuer concentration, expected recoveries on defaulted bonds, age of the market, economic stability, and interest rate volatility.Another category of explanations emerged from discussions with syndicate and sales professionals familiar with both the European and U.S. high-yield markets. They maintained that European portfolio managers respond differently from their U.S. counterparts when a credit problem comes to light. According to these sources, European investors are more willing to sell at a substantial loss and few of them seek to profit from market overreactions by scooping up bonds at distressed prices. Observation of the marketplace cast doubt on the informants’ further assertion that European high-yield investors either lack experience in credit analysis or sell in the face of bad news without undertaking thorough credit work.Alternatively, the tendency of some European managers to react swiftly might be culturally instilled. Perhaps attitudes toward risk vary geographically according to experience with such events as wars, natural disasters, massive currency devaluations, nationalizations, and security price collapses that follow speculative excesses. Furthermore, the narratives about such occurrences passed down from generation to generation may be shaped by each nation’s concepts of cause and effect, blame, and appropriate responses to hardship. In summary, cultural factors are potentially one of the missing pieces in explaining the persistent phenomenon of price volatility.