The Epidemiology of Volatility Transmission

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This is part 1 of a two-part series, “The Epidemiology of Volatility Transmission and Management.” In part 1, I use a 1927 mathematical model to illustrate the parallel paths traveled by infectious viruses and market volatility. Part 1 continues with a discussion on the role of superspreaders – in the context of both infectious disease spread and volatility transmission. Part 2 concludes with how investors can use VIX-linked securities as a left-tail risk hedge or a distinct, tradeable asset class.

How a volatility virus and pathogens collided in the COVID crisis

The COVID crisis is a human tragedy that has had an enormous impact on the global investment climate. It’s also an important reminder of the humbling and daunting task for investment professionals. We are tasked with shaping favorable investment outcomes and solutions for the investors and stakeholders we serve. As the pandemic hit, structural shifts in consumer demand due to stay-at-home orders and lockdowns wreaked havoc on prediction models slow to adapt to unusual data patterns.

The novel coronavirus and COVID-19 pandemic changed the way we live, work, eat, communicate and invest. The pandemic has brought into focus parallel paths traveled by infectious viruses and market volatility.1 Volatility, like infectious disease, is transmitted through common sources of infection.

Volatility is transmitted through investor psychology, market contagion and liquidity pressures. Volatility can be and is amplified by social media and central bank action (or inaction), through network dynamics. The COVID crisis has driven an increased appreciation for a systemic perspective and robust model to forecast volatility transmission. Investors and their advisors can gain valuable insight by applying epidemiological models to volatility transmission.