The following report provides an update on some of the metrics I use to classify market risk. The word classify is more appropriate as I think that in essence you cannot forecast risk but rather attempt to adjust to it into a timely fashion. Clearly risk would not be a risk if you could forecast it accurately. However as there is generally some degree of persistence in risk regimes, using a dynamic classification may prove a useful approach for portfolio rebalancing and hedging. In this report I use the S&P/TSX 60 VIXÂ® index (VIXC) which estimates the 30-day volatility of the Canadian stock market implied by the near-term and next-term options on the S&P/TSX 60 index. The VIXC methodology uses S&P/TSX 60 index options, VIXC is a good proxy of investor sentiment for the Canadian equity market: the higher the index, the greater the risk of market turmoil. A rising index therefore reflects the heightened fears of investors for the coming month. VIXC also gives an indication of whether options are relatively cheap or expensive, as the higher the implied volatility, the higher option premiums are. The same methodology can be successfully applied to other inputs. Feel free to contact me at email@example.com for more information on the subject.
In my approach I recognise that the nominal level of implied volatility is a crude metric of risk therefore I also use two other measures. The VIXC Volga, a measure of uncertainty of risk and the ShockIndex a measure of market dislocation. VIXC Volga is simply the volatility of the VIXC over a period of 21 days. This measure highlights how uncertain and unstable the level of risk has become. Though positively correlated to the level of the VIXC the VIXC Volga is not necessarily dependent on it. You can have a high level of volga whilst the VIXC is trading at rather innocuous levels. This is not a trivial observation as the leverage undertaken by market participants tends to be an inverse function of market volatility which implies a greater vulnerability when volatility becomes uncertain at low levels and therefore cannot be accurately budgeted for. The ShockIndex is the ratio between the Volga and VIXC at the beginning the historical window chosen to evaluate the Volga. It quantifies sharp changes and acceleration in risk levels. Historically it has proven to be a good classifying measure for market event risks.
The below charts shows those three measures both relative to a time axis and their historical distribution. The red lines are the 95% confidence intervals, the purple line the median. The blue line highlight the current level. The VIXC Volga and ShockIndex in this report are evaluated over a period of 14 days. The medians and 95% confidence intervals are calculated over the full history going back to 2009.
At close of business the 2016-05-12 the S&P/TSX 60 VIX Index was trading at 16.4 at the 51.7 percentile. The 14-day S&P/TSX 60 VIX Index Volga was estimated at 23 its 85.7 percentile and the shockindex at 1.5 or its 86.8 percentile.
The above charts are useful, however their visualisation is quite limiting. On the one hand we need quite a few charts to present the data on the other hand looking at the full S&P/TSX 60 VIX Index history somehow reduce the information granularity. Therefore clustering and aggregating the whole data into a single chart should be useful to the end user. To answer this I use a mapping technique developed by Kohonen in the 1980′. It uses an unsupervised neural network to re-arrange data around meaningful clusters. Though computationally complex is a practical way to summarise multidimensional data into a low (usually 2) dimensional system.
The below chart shows how the S&P/TSX 60 VIX Index price history was split into 4 distinct clusters. Those clusters where computed not only as a function of the S&P/TSX 60 VIX Index level but also as a function of the other variables, namely S&P/TSX 60 VIX Index volga and Shockindex.
Since 2009 the S&P/TSX 60 VIX Index traded 21 % of the time in Cluster 1, 52 % in Cluster 2, 20 % in Cluster 3 and 7 % in Cluster 4. Overall the layering provided seems quite intuitive as the increase in risk and time spent in each cluster points toward what would generally be expected from market risk regimes ranging from low to high risk.
In the chart below we zoom on the various regimes within which the S&P/TSX 60 VIX Index has been trading for the current year. so far it traded 68 % of the time in Cluster 1, 12 % in Cluster 2, 4 % in Cluster 3 and 16 % in Cluster 4.
Finally the below chart shows a Self Organising Map of the above mentioned risk metrics. The data has been grouped and colored as a function of four clusters of increasing market risk regimes. Obviously as shown on the map, the minimum level of volatility pertains to cluster 1 and the highest to cluster4. The current regime and its progression from 21 days ago is also highlighted on the map.
Always happy to discuss any of the above, feel free to reach me at: firstname.lastname@example.org