Volatility spiked last week and we again were reading stories about how this was intensified by systematic traders who were cutting positions as a knee-jerk response to the initial volatility shock. We don't dispute that expected returns respond to volatility or that risk management may lead to further market selling. It is the level of feedback that is unclear. Investors have to get used to the fact that this volatility feedback loop is here to stay.
Our simple diagram shows how a shock to markets will lead to a feedback loop and the potential for more selling and an increase in correlation for those markets within an asset class. We have not shown the impact of dealer adjustments from gamma trading which is another feedback path.
A volatility feedback loop exists for any investment manager that uses VaR as a means of measuring risk and for any asset manager that adjusts positions based on volatility or targets portfolio volatility. The exogenous volatility shock affects trading behavior which leads to endogenous risks that lead to further increases in volatility The only question is measuring the size of the impact between portfolio behavior and volatility and the speed of the response to an initial shock. Investors should not be complacent to the feedback from volatility shocks.
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