Remember The Protest Against Black Swans?

We originally posted this on March 7. It concerned the bizarre lack of protection-buying, even in light of the widening crisis in the Mideast. Citi's Steven Englander proposed that investors were protesting against a neverending string of "Black Swans" that never actually emerged, and he recommended buying tail risk protection. Well, now we're actually seeing a real crisis. The post is worth a re-read.

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An interesting conjecture from Citi's FX guru Steven Englander, who notes that volatility remains remarkably low.

Here, for example, is AUDJPY volatility, which remains at post-crisis lows.

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What explains this?

Investors are on strike against black swans -- specifically...

Our conjecture is that investors are tired of being told to hedge against risks that have not emerged, and where the positions end up as costly in terms of premium paid out. (And it is an obvious truth that the kids outside playing in the snow without sweaters and scarves seemed to have much more fun than those of us who were bundled up.) Indeed the downward trend in vol may reflect that too much optionality was bought to hedge risks that didn't happen and now it is being disgorged back into the market.

In recent weeks we have been arguing that tail risk remains and is unusually realistic given the potential sources of shocks. We have also found that in many cases clients are reluctant to buy into these fat tail scenarios (actually 'reject' may more accurate than ' are reluctant' ). The argument is basically that they have heard it many times before in the last two years and asset markets have continued to flourish.

We would argue that the correct approach is to ask whether the macro risks looking ahead are those that can be dealt with using the policy tools at hand. If not, the tail risk scenarios are more concrete. Conversely if the asset market bounce and rebound in high-beta currencies over the last two years can be explained largely as the result of massive liquidity injections globally and significant fiscal policy ease, the question looking ahead is whether these policy tools will be equally effective in dealing with the future shocks.

Englander is talking currencies here, but the thinking could easily be applied to equities. Just because none of the myriad black swans have emerged over the last 2 years, doesn't mean they can't still.

For an equivalent look at what it costs to buy protection in the equity world, here's the VIX. It's definitely jumped recently, but it's still very cheap compared to where we have been.

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