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Market Beliefs and Optimal Policy in the Presence of Disasters

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‘Index of fear’ puts a price on market turmoil

A new measure of market volatility can inform our response to disasters of both the market and the wider world.

Society

A financial measure that can help us understand how markets are likely to respond to sudden unexpected events, from interest rate cuts to terrorist attacks, was the goal of the EU-funded Disasters project. Among other things, the project provided a way to measure the expected return on the market, or equity premium. This quantity is hard to measure, and the conventional wisdom holds that it moves fairly slowly over time. However, project coordinator Ian Martin says this is misguided. “It behaves in a much more spiky way than people previously thought,” he explains. “You can think of it as an index of fear. At times when things are going pear-shaped, you have to offer extremely high rates of return to induce people to go into or stay in the market.”

Irrational beliefs

During times of economic turmoil, known as Black Swan events, investors are liable to withdraw their money from the market and place it into safer economic vehicles. Using the associated volatility index (SVIX), a measure Martin developed that quickly and accurately reflects the equity premium, Martin hopes that investors can be induced to keep their money in the market by seeing how much they stand to gain. Overall, this should reduce the impact of these crises. “My approach is step away from extreme rationality and allow for the presence of irrational people or people with strange beliefs,” adds Martin. “The question then becomes: As a rational investor surrounded by these irrational people, what kind of return would you have to anticipate in order to be happy to put your money in the stock market?” The SVIX index provides the answer.

Wider disasters

The underlying mathematics also prove to be useful for investigating the impact of disasters beyond the stock market. “The mathematical tools you need to study extreme events in the stock market are also helpful for thinking about policy reactions to disasters more generally,” he notes. The main lesson these models reveal, he says, is that catastrophes cannot be approached sensibly as discrete events separate from one another. In a paper discussing the research, Martin and his co-author Robert S. Pindyck analyse how the cost-benefit assessment of averting disasters breaks down when working with multiple overlapping possibilities. The work carried out for the Disasters project can help inform policymakers which of these events are the most important to address.

Dramatic events

The research was supported by the European Research Council. “This gave me the time to do it – time is by far the most important thing,” says Martin. “It enabled me to work with co-authors in Copenhagen, Bristol and Boston, and to travel to present this work in China, the EU and the United States.” Having developed the technique for measuring market expectations, says Martin, it can also be used to look at how the market reacts to information, particularly around big shocks. “If you adopt the conventional approach that uses historical averages as a proxy for forward-looking expectations, your data will react sluggishly to dramatic events – when Lehman Brothers collapses, when the plane hits the World Trade Center or when a pandemic hits,” he adds. “My approach should have a particular advantage at times such as these. And once you have a good measure of forward-looking expectations, there are a hundred and one things you can apply it to.”

Keywords

Disasters, market, volatility, expected, return, index, fear, SVIX, Martin, equity, premium

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