Saturday, May 3, 2008

Where did the risk go?

The Volatility Index (invented by colleague Bob Whaley) which measures the implied risk in options prices (the higher the options price, the bigger implied risk) is down to 18% from a high of 32% in March. This means that the expected change (the standard deviation) in the returns from holding the S&P index for the next year is 19%. The decline in risk has corresponded to an increase in the price of the S&P 500. The market "prices" the decline in risk by reducing the risk premium necessary to get investors to hold the risky asset. A higher current price means lower expected future return, and thus a lower risk premium for holding stocks.Or for a longer run view,

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