The Random Walk

Financial market analysis

*Pictures from Hargreaves- Lansdown

Edited by:
Miles Hamilton
Adrian Booth

Contributions from:
William Whyte
The Fear gauge
In this era of political uncertainty and worry over sovereign risk, doubts about the global recovery have resurfaced
and volatility has returned with a vengeance. This development is captured by the VIX index and this article gives a
brief look into why. By Miles Hamilton

The VIX index, the US barometer of Volatility measures

risk aversion- dubbed as the ‘fear gauge‟- has 30

lingered around the 20 mark for the last few 25

months as investor complacency fed its way into

the financial markets. This was something 20

David Rosenberg pointed at early last month, 15

suggesting a ‘corrective phase‟ was impending-

and this week the ‘phase’ began as complacency 10

got shaken out the market. 5

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SPX Index - Volatility 30 Day (R1) VIX Index - Last Price (R1)

By comparing the implied future volatility of the

VIX to the actual S&P 500's volatility, it's
possible to gauge whether the options
underlying the index are cheap, expensive or
fairly valued as a group. As a result, it's also
possible to judge how traders and investors view
the trading pattern for stocks.

As the diagram shows, VIX activity soared by
55% in the third week of January with call
options amounting 1.66m and put options
524,108 as investors attempted to hedge
themselves as policy confusion gripped the
market. Investors fretted about the impact of the
Obama administration's proposed restrictions on
banks and the fate of Federal Reserve Chairman
Ben Bernanke and as a result, option buyers
betted that markets were going to decrease
further and so they bid up prices in order to
protect their assets.
Herb Kurlan, Chief Executive of Vtrader Pro
suggested that; "The VIX is just reflecting the
troubles in the financial stocks and how it is
going to affect all the market. That is why we
are seeing such a big jump". While I do agree
with this statement, I feel that Kurlan missed an
important point. The VIX index represents what
investor’s perceive to be trouble within the
market and based on how they think the market
will react to certain events.
This is captured by comparing the VIX index to
the S&P volatility index which is shown in the
following diagram.
When U.S. stocks swooned in the third week of
January, the VIX jumped far more than the S&P
500's volatility did as reflected in the graph
above. The S&P volatility was at 15 whereas the
VIX index exceeded 27. What this conveys is
that investors perceived a danger that did not
correlate to the actual markets. As David
Wilson from Bloomberg said to me in an email;
„It appeared that people anticipated bigger
swings in stocks would persist. When they
didn't, the VIX settled down a bit.‟ Essentially,
the comparison shows the interrelationship
between expectations and reality.
Interestingly, the VIX index has began in recent
months to realign itself to the volatility in the
bond market. There seems to be less of a
discrepancy between the bond market-
represented by the MOVE index and the equity
market reflected by the VIX index. In fact, there
is the lowest spread since late 2007 and the
correlation between the two indexes has
increased by 220% since September 2009. What
this seems to indicate in my view is that the
massive government debt which had initially
put fear into the bond market is now feeding its
way into equity markets.

The Random Walk- Issue 1- Jan 2010 1 Cass Business School

The VIX index has come under criticism lately,
for being a ‘pedestrian measure‟ as Tobias
Levkovich remarked, suggesting that it has lost
its power on the basis that it signals too late for
investors to respond meaningfully. I disagree
with this, however, as it is by the very nature of
volatility that it ‘occurs in regimes, meaning
that it is persistent through months of time as
information is disseminated through the market‟
(SurlyTrader). Ultimately, the VIX index has
strength as a measure that shows what investors
expect to happen within the economy. ■
Inflation?
With the V.A.T. increase not only individuals but
the market seems to be hinting that inflation is
imminent. By Miles Hamilton
As the economic recovery gains momentum,
individuals seem to have become increasingly
concerned that consumer price may be poised to
increase. This has manifested itself in the spread
between nominal and inflation linked bonds. As
investors have begun to fear inflation, they have
invested in index linked bonds which has
increased prices and lowered yields relative to
nominal bonds.
The result is that the breakeven rate has
rebounded to levels that prevailed prior to the
Sept. 15, 2008 collapse of Lehman Brothers.
“These movements are signalling that inflation
is starting to become a focus in the market,
particularly over the medium term,” said
Michael Pond, Barclays Plc.
The reason why inflation is suddenly coming
into focus is highlighted by Robert Johnson
from Morningstar. He reproduced the
government's list of inflation by category-
shown in the table below- arranging the lists
from deflationary items to the ones with the
highest rate of inflation. He noted that many of
the items on the list have values above 3% but
these are suppressed by the ‘tame’ shelter
category which has the largest weight in the
index. With heightening demand and over
performance in the manufacturing sector, the
shelter category may not be able to suppress
inflation any longer. ■
Dec. 08 to Dec. 09 Price Increases %
All Items 2.7
All items less food and energy 1.8
Utility (piped) gas service -18.1
Food at home -2.4

Electricity -0.5

Shelter 0.3

Food away from home 1.9

Apparel 1.9

Medical care commodities 3.3

Medical care services 3.4

Transportation services 3.9

New vehicles 4.9

Thus, as the graph above shows, the spread - Fuel oil 6.5

also known as the breakeven inflation rate- has Used cars and trucks 9.2
increased, indicating that people seek protection
Gasoline 53.5
by index linked bonds from inflation risk. This
was recently shown in the Markit/ YouGov
survey which concluded that „80% of those
surveyed expect average prices to be higher one
year from now’. (Self, A. 2010).

The Random Walk- Issue 1- Jan 2010 2 Cass Business School

 Trade of the decade
Many market commentators argue that Gold is in a bubble, but this article questions that position suggesting
that it is relatively undervalued considering its potential strong long-term outlook. By Adrian Booth

The theme for 2010 and the rest of the decade policy of currency debasement, gold and
lie in currencies and commodities. The inflation commodities are the only sensible place to
trade is coming back as governments frighten invest.
gold bugs and bond vigilantes by printing
money to pay the bills. The word on the street is The U.S. dollar index has dropped 7.25% in the
that gold is in a bubble. Various commentators space of a year (as of February 3rd). Meanwhile,
from Nouriel Roubini to George Soros have gold is up 24.2% from a year ago. In other
expressed this view. The table below shows a words, for every 1% drop in the dollar index,
list of 10 precious and industrial metals. Those gold has risen 3.35%. If that approximate
calling a bubble in gold clearly have not done percentage holds over time, one can begin to
their homework. Out off all the metals gold is in estimate what the gold price might be if you
fact the lagging know what the dollar might do.
performer, rising The long-term fate of
only 24% in a the dollar has already
year compared to dried in cement. If
copper and the dollar were
palladium which simply to return to its
have had triple March 2008 low of
digit advances. 71.30 this year or next – an 11.4% drop from
This newspaper disagrees with Roubini and current levels – this would imply a rise in gold
other market commentators who have repeatedly of 38.19% and a price of about $1,544 an ounce.
said gold is in a bubble. Just from using Many analysts claim a price of $2000 an ounce
economic logic it is almost inevitable that the for gold is absurd, but this price is not a radical
dollar will decline in the long run. Seeing as assumption. This price can be easily reached
there is an indirect correlation between the value over 10 years if gold rises just 5-6% a year. In
of the US Dollar and the price of gold, the long real inflation adjusted terms, the gold price has
term outlook for gold is strong. Currently the still not breached its all time high of $2189 that
US dollar has rallied somewhat due to the it reached in the 1970s.
problems in Greece and the vulnerability of the
Euro. This has led to a correction in gold and led
many to call a premature end to the gold bull
market.
The table above shows a brief overview of the
previous gold bull market of the 1970s and the
significant rises that occurred during this
inflationary period. 1971 was the year that the
world’s monetary system was placed purely on a
fiat paper money system when the international
gold standard was abolished by Richard Nixon.
During the 4 years leading up to 1974 gold
rallied 471% only to then have a two year
correction of 50% when many thought the bull
had died. Those investors that hung on to their
gold holdings gained a further 750% as the
dollar declined. Compared to the 1970s run, the
current bull market is still in its infancy. With
governments and central banks following a

The Random Walk- Issue 1- Jan 2010 3 Cass Business School

 The chart above shows the real and nominal
value of gold going back to 1913. It is hard to
argue for a gold bubble when the metal has
failed to breach its all time high, the price rise
has been moderate and central banks are
engaging in risky monetary experiments that
threaten the value of paper currency. Gold has
been currency for thousands of years and is due
for a comeback. The investment battlefield over
the next decade will be fiat money versus gold.
Every paper currency in history has crashed and
become worthless; this time is no different. We
can expect further turmoil in the currency
markets and a rush to gold and precious metals
in the next decade. ■
Black and yellow gold
In the previous article it was made clear that
gold has fallen in value, but it is oil that has
suffered worse price falls. By William Whyte
and Miles Hamilton
As the result of a post-New Year sell-off, Gold
and oil have both fallen in value. Crude
contracts are off nearly $8 a barrel, or 9.5%,
since the top of the year; spot gold's slipped
only $16 an ounce, or 1.5%. This is reflected in
the gold/oil ratio which now stands at 15
meaning that an ounce of gold can now buy 15
barrels of oil. This is a more sustainable level
than the 27- 1 a year ago.
As of January 29th 2010, the price of crude oil
stood at just over $74.43 a barrel. In relation to
the $125-130 heights and ($40 low) of 2008,
The Random Walk- Issue 1- Jan 2010
this price can be seen as a return to the stable,
gently rising, two-figure normality of 2007.
Oil prices in the US fell more than 8 percent in
January, pressured by weak energy demand,
worries about fiscal turmoil in the euro- zone
countries and a stronger U.S. dollar. The US
dollar broke out of its trend tunnel, as the graph
below shows in mid December, rising
substantially throughout January as investors
sought the safety of the dollar.
As the dollar gained value, oil prices fell
because the higher dollar made the dollar-priced
commodity more expensive for holders of other
currencies, contracting demand.
So, we feel that oil is underpriced considering
that a barrel of Perrier sparkling water would set
you back $300 a barrel and a Starbucks Latte in
such form would be priced at $920 per barrel.
Coupled with the likely supply restrictions to
which OPEC may agree (due to the breaches of
Nigeria’s supply increases), oil may well be a
worthwhile investment. ■
Interesting fact: why oil is measured in barrels.
Strictly speaking, a barrel should be exactly 42
gallons, no more, no less. As they are often metal
and sturdy, they were perfect to contain oil when
first drilled, because, if the Daniel Day Lewis film
‘There Will Be Blood’ has taught us anything, once
you find oil, it erupts out of the ground
uncontrollably and must be containing as quickly
and easily as possible in durable, divisible
containers. Obviously once traded, a standardized
size container was inevitable, and 42 gallons was
agreed upon.
4 Cass Business School
 Sovereign Risk
Tainted as the „New subprime‟ by Gilliant Tett, the growing concern over sovereign debt has lead to increasing risk
of default. This article, however, distinguishes between two key risks that are prevalent in the markets; default and
price risk. By Miles Hamilton
With governments running large fiscal deficits
to help support their economies, as well as
expansionary monetary policies, there has been
a growing concern over the credit worthiness of
government finances. The risk related to
sovereign debt has affected many countries,
however, It is clear that the risk affecting
Greece because if its debt levels is much
different to that of the UK. Thus, what is
essential is a distinction between the risk of
default and price risk.
Greece and the risk of default
With Greek bond yields up more than 150 basis
points in a month, it has become clear that
investors have factored into Greek bonds a
significant default risk. In fact, Greece is
offering more yield than investors demand from
emerging-market borrowers including Vietnam
and Indonesia to sell its first bonds of the year,
according to data compiled by Bloomberg.
Ironically, it seems that the same mistakes that
were made lending money to less than qualified
mortgage borrowers are now being made
lending money to less than qualified nation
borrowers.
The result, as the above graphs shows, was that
there was a rapid deterioration in the perception
of Greece’s credit quality and so credit default
swaps on Greek government debt climbed to an
all time high of 378.5.
Greece is running a budget deficit of 12.5%
which far exceeds the 3% that they are supposed
to keep to under the Maastricht Treaty. This is a
serious problem and it is highlighted by the fact
that its current €254 billion of debt is 5 times
the level of Russia when it defaulted on its debt
in 1998. Greece’s GDP was €240 billion in
2008 and so it is clear that it has a debt to GDP
ratio of well above 100% which exceeds the
60% limit of the treaty.
In the past, investors have had confidence in
Greece because of its presence in the Euro zone
and now that confidence is eroding daily. The
impact that this has had on investors can clearly
be seen in the value of the Euro.

On the 26th of January, Greece successfully sold

€8bn in new bonds to investors, however, a
week later prices collapsed and yields increased
to 6.50%. The reason behind this is that “many
of the investors were 'hot money' funds that
bought on rumors that China was emerging as a
buyer, offering them a chance for quick profit.
When the China story was denied by Beijing
and Athens, these funds rushed for the exit."
(Marc Ostwald, from Monument Securities).
The graph above shows the Euro against the
Dollar and how the Euro tracked the fiscal
concerns linked to Greece represented by the
substantial decline in the latter portion of the
graph. Caused by the relentless selling of
Eurozone debt, the devaluation of the Euro
fundamentally underscores the decline in
investor sentiment and faith in Greece’s fiscal
position. The surge in credit default swaps
coincided with this devaluation as investors

The Random Walk- Issue 1- Jan 2010 5 Cass Business School

sought to hedge from debt using the CDS and pricing distortion with the government bond
from the Euro by switched to the safety of the market. Prices have been underpinned by the
USD. fact that investors have had a guaranteed buyer
of gilts from the asset purchasing scheme and
Nevertheless, the government of Greece
therefore, many expect that when the scheme is
recognized that it could not continue to run such
finished prices will readjust and fall.
huge deficits. They have developed a plan that
Government bonds yields, thus, seem to reflect
aims to narrow the shortfall from 12.7% of
how they are ‘risk free‟ in their return but how
output to 8.7% this year. Professor Philip
they could be toxic in their supply.
Arestis and Theodore Pelagidis believe that
Greece can achieve this plan and they suggest
Supply is a crucial factor and I feel that it will
that most of the articles published recently in
become instrumental in the future. Current
the press ‘exaggerate Greece‟s economic
prices seem to only reflect the involvement of
misfortunes and underestimate its prospects‟.
the asset purchasing scheme but as Robert
They contend that data shows that direct taxes
Stheeman has suggested, when this is
in Greece as a percentage of GDP are around
withdrawn and the execrable finances are then
6% lower than other countries and they suggest
the main price determinant, prices will be
that if this was to be utilised by a tax increase,
substantially depressed. This could be a problem
there would be an increase in tax revenues of
if investors think the level of debt is
€16bn.
unsustainable because it could lead to mass
Ultimately, the fate of Greece will be decided
selling which would depress prices. As Gary
by how investor confidence changes from now.
Jenkins stated; ‘The biggest single risk hanging
If the Greek population lose confidence to the
over the bond markets is the rapid rise in public
point that they liquefy or transfer their savings,
debt’ (Oakley, T. 2009).
then there may be bank runs in Greece.
However, if confidence is rooted in the Ultimately, there is a distinction between the
Eurozone is retained then European policy sets of risks faced by the UK and Greece
makers could still have an opportunity to find a however, they underscore an important point
solution to Greece’s problems. According to the that they root from the same fundamental
Monetary Affairs Commissioner Joaquin problem. ‘The lasting legacy of this crisis is too
Almunia the latter will be the case and "Greece much debt held by too many sectors against too
will not default” because “In the euro area, little capital.‟ (Andrew Haldane of Bank of
default does not exist." England) ■
UK and the price risk

While the UK has an intractable fiscal position,

the result has not been a huge loss in confidence
in the UK’s solvency. Rather, the risk that is
prevalent in the UK is the risk with respect to
bond prices. As J. Grant stated "There is no such
thing as bad bonds, only bad bond prices".

This was underscored by Warren Buffett who

warned that owning government bonds is no
riskless enterprise, writing that, "clinging to ...
long-term government bonds at present yields is
almost certainly a terrible policy if continued
for long." The reason for this is that the asset
purchasing scheme has been pushing up bond
prices to artificially high levels leading to a

The Random Walk- Issue 1- Jan 2010 6 Cass Business School

Waiting for the exit
The exit strategy of banks is a key issue, however, it is one that could be exacerbated in the long run if the
Fed carriers on paying interest on reserves. By Adrian Booth
The main theme in the markets remains the exit
strategies of central banks. To explain what’s
currently going on in the money markets we
must refer to the following charts.
The chart above shows the monetary base of the
Federal Reserve. This is all currency in the
economy plus reserves with the central bank.
When banks deposit money at the Fed, this
shows up in what’s known as excess reserves. In
normal times this is usually $1 billion, as shown
by the second chart. It has now exceeded $1
trillion, an abnormal figure.
In normal times a rapid increase in the monetary
base, also known as narrow money, would lead
to inflation. Because this money is not being
The Random Walk- Issue 1- Jan 2010
lent out and is on deposit with the Fed, the rise
in narrow money is not leading to a rise in other
forms of money supply. In other words, it’s not
making its way into the pockets of consumers.
But why would banks keep reserves on deposit
with the Fed? One reason could be that they feel
apprehensive about the economy and refuse to
lend money out for fear of losing it. The other
reason is that the Fed is literally bribing the
banks to not lend money out by paying them
interest on these reserves, a policy Ben
Bernanke, Fed Chairman, initiated back in 2008.
For those who think that policymakers are doing
all they can to boost lending, ask why would the
Fed pay interest on these reserves. Eventually
banks will begin to lend this money out, which
will lead to severe price inflation if the Fed does
not act quickly enough. But the longer the Fed
pays interest on reserves, and the monetary base
grows exponentially, the problem is only going
to get worse as time goes on. ■
This article features views and ideas that intend to give a
subject account of market events. Thus, they are purely an
expression of opinion.
This article is the property of Cass Business School and is
intended for the exclusive use of students and teachers of
Cass Business School. Unauthorized reproduction or
distribution of this material in whole or in part is strictly
prohibited. Please consult Miles Hamilton for further
information;
Email: miles.hamilton.1@cass.city.ac.uk
7 Cass Business School