IMF warns of risks from volatility products

The increasing use of exotic instruments could lead to a severe shock to financial markets

IMF warns of risks from volatility products
The International Monetary Fund (IMF) has raised concerns of a possible financial-market shock as investors such as pension funds increase their use of financial products tied to equity volatility.

According to Tobias Adrian, director of the IMF’s Monetary and Capital Markets Department, a desire for yield is pushing investors to embrace ways to juice their income using complex instruments.

“The combination of low yields and low volatility facilitates the use of leverage by investors to increase returns, and we have seen rapid growth in some types of products that do this,” Adrian told the Financial Times in an interview. Estimates from the IMF peg the assets invested in volatility trading strategies at around US$500 billion, rising by more than half over the past three years.

The Vix, which measures equity market volatility and has historically averaged around 20, is hovering at levels close to 10. The IMF believes that this is pushing investors into higher leverage levels. At the same time, models that rely heavily on volatility could be understating the amount of exposure participants may have.

“A sustained increase in volatility could then trigger a sell-off in the assets underlying these products, amplifying the shock to markets,” Adrian said.

According to the Times, there’s mounting evidence that pension funds and insurance companies are pursuing income by wading deeper into riskier investments. Some are also said to be effectively writing insurance contracts against a market crash so that they could pocket premiums.

Clients of JPMorgan were also warned last month about “strategies that sell on autopilot,” particularly due to risk management models that utilize volatility. “Very expensive assets often have very low volatility, and despite downside risk are deemed perfectly safe by these models,” wrote Marko Kolanovic, head of macro, derivative and quantitative Strategies at the firm.

Since most deals involving complex volatility-linked products are done privately, it’s hard to be sure about the true quantity of such products. That has made it challenging for regulators to pin down the possible risks to the market in case a sudden shock occurs.

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