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“Volatility” is one of the most mentioned concepts in financial markets. This word may carry a positive connotation, but it may also be used in more complex scenarios. This column provides an in-depth explanation of its characteristics so as to attain a better understanding of this word.

 

To begin with, we will say that volatility is a measure of the fluctuation in the price and profitability of a security, whether it be stocks, bonds, currencies, or any other asset. It derives from the fact that such securities are traded in markets subject to constant variations in supply and demand. Two measures are used to support this analysis: the standard deviation and the beta. The former calculates the dispersion of a price relative to its mean, whereas the latter measures its sensitivity to the market.

As an example, let us analyze last year’s Amazon and Tesla stock standard deviation, which amounted to 1.70% and 3.46%, respectively. In this comparison, Tesla comes across as the most volatile. In Chart 1 we can visualize this behavior, and observe how Tesla‘s dispersion of returns compared to its mean is higher than Amazon‘s.

Chart 1. Own elaboration. Data: Bloomberg

But an additional factor must be considered to analyze these securities: our risk profile, which plays a key role in our investment decisions. If we were to consider standard deviation alone, a risk-loving investor would choose Tesla stocks: their volatility offers the chance of higher profits, even if it came with the risk of greater loss. Whereas, in this situation, a risk-averse investor would choose Amazon to reduce his risk exposure.

Now, with a clearer understanding of the concept, we can see how it can be applied to two specific cases that took place in recent weeks: the increase in oil and natural gas prices, and the impact that Evergrande‘s financial situation has had on Hong Kong Stock Exchange.

 

The Hydrocarbon Market

This year’s global economic recovery has led to an increase in the demand for hydrocarbons, as could be expected. The result of this accelerated increase in demand came as a surprise, though: inventories accumulated from previous years were rapidly consumed, and some doubt about the producers’ capacity to meet the demand.

For a better comprehension of this behavior, Chart 2 presents a comparison between the prices of Brent crude oil and natural gas futures. Between August and October, the latter has exhibited both a marked increase and greater fluctuation. In figures, between August 1 and October 8 (red box), the growth rate for Brent crude oil totaled 13.03%, whereas the one for natural gas amounted to 41.42%. In addition, and to obtain a general picture, the volatility for each series during last year was 1.96% and 3.12%, respectively.

Chart 2. Own elaboration. Data: Bloomberg

 

When it comes to discussing the rationale behind Chart 2 trends, the most significant forces for crude oil are the OPEC+ maintaining its increase of 400,000 barrels per day during October and November, and the fact that the shale oil industry in the US has not returned to its pre-pandemic levels yet, which reinforces investors’ perception that production will not suffice to meet the growing demand.

Concerning natural gas, two main factors fuel this scenario: the substitution of coal for gas in European industries, and the arrival of winter in the northern hemisphere, with the consequent increase in the demand for household heating. But analyzing the data regarding volatility, the natural gas market presents greater uncertainty levels for investors, causing quick changes in buying and selling positions, and the consequent price fluctuation.

 

Evergrande and Hong Kong

In my lectures and courses, I always mention that, regarding volatility, it must be remembered that a series is not constant over time: it variates as new information influences investors’ decisions and expectations.

To clarify this point, Chart 3 shows the Hong Kong Stock Exchange Hang Seng index behavior during last year, divided into three equal periods: the first period goes up to February 8, the second to June 6, and the third one to October 10.

Chart 3. Own elaboration. Data: Bloomberg

When the volatility for each of these segments is calculated, the standard deviation amounts to 1.06%, 1.19%, and 1.36%, versus an annual measurement of 1.22%. It does not come as a surprise, then, that it was during this last period that the case of the Chinese real estate company Evergrande has gained momentum, and some are talking about the possibility of systemic risk. All of this plus the implementation of more and more regulatory measures by the government resulted in greater uncertainty as to the stability of the markets in that country. This, in turn, leads to a buying and selling positions behavior similar to the one observed in the case of crude oil and gas.

In conclusion, regardless of whether the comparison is made between series of different securities, or between historical periods of one of them, volatility is an inherent element in financial markets and will always be present, since it is the most immediate representation of market risk. The way an investment decision is made is strongly influenced by the combination of risk appetite and volatility. That is why thorough comprehension of the markets’ standing points on the subject is crucial.

 

 

This report was written by Gandini Analysis for SupraBrokers only as content. It shall in no case be considered an investment recommendation.

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