Analysing the volatility index: How disease outbreak news impacts equity and commodity markets

(Image: REUTERS)

By Imlak Shaikh

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The infectious disease outbreak has infected the global financial system unprecedentedly; investors are forced to rebalance all investments and allied derivatives (F&Os) following the current contagion developments. The COVID-19 diseases outbreak contains many consequences — it has impacted the investment and savings and labor productivity and economic activity, and different approaches to risk management. The economic crises and transmission of infectious diseases hold a close relation; for example, a global financial crisis that occurred during 2008-09 encompassed H1N1, which indicates a long-run impact of crises on the global healthcare system. 

To account for the future impact of COVID-19, it’s essential to have a robust system for the database that can help in forecasting. Hence, health establishments insist upon the digestible input data to perform economic and financial forecasting. The world media and analysts have paid much attention to the likely impact of COVID-19 on financial markets. It has been seen that COVID-19 induced uncertainty has put much pressure on the well-developed and emerging markets not only for equity market but an uncontained impact on the commodities as well; the current state of the market is calm, but wait and watch! An announcement of the global health emergency from the World Health Organization slanted the Dow Jones Industrial Average. It appeared low historically with high fear and anxiety in the last 11 years. 

The Chicago Board of Options Exchange’s implied volatility index (VIX) historically appeared 82.69%, at the highest level on March 16, 2020, while it was about 80% in 2008. In relation to the fear among emerging market investors, India Nifty VIX measured about 83.61%, China’s VHSI 64.80%, and Japan’s VXJ 60.67%. It indicates that the Asian market exhibited extreme fear amid COVID-19 infection during the first quarter of 2020. Hence, during the period of ambiguity, investors are unaware of the future consequences of the market and keep on buying put options; consequently, VIX level goes up. During the initial period of the pandemic, investors rushed for hedge funds. On March 18, 2020, the put/call ratio of SPX index options appeared to be 2.48, which is more than unity and implies excessive trading volume in the put options. Consequently, it led to a higher premium on the put options resulting in higher implied volatility. The put/call ratio is the gauge of the market sentiment; a higher ratio indicates greater fear in the market.

Investor’s fear on the diseases outbreak new (COVID-19) 2020

Looking at the market cap of the US equity market, around 10% consist of energy firms. Hence, investing in energy companies allows you better exposure to the energy markets. The COVID-19 outbreak has speedily disrupted the global supply chain and the economy; eventually, it has led to a histrionic change in the energy markets. Brent oil prices have distorted around 60% since the start of the year 2020, while US crude futures (WTI) have fallen about 130% to levels well below -$37/b, and the oil volatility index (OVX) stood at its peak of 190.08%. The demand for energy and supply depends on the perseverance of COVID-19; further, the lockdown, unlock and social distancing, and new workplace norms. There have been monumental swings in the global crude oil prices, and they dropped 50-80% in the first quarter of 2020. For the first time in the history of oil futures, WTI and Brent in near-term curves have fallen on average 20%, and oil and gas companies face a growing risk of insolvency. Furthermore, looking at the investors’ fear in the foreign exchange market considering major three currencies against USD. It’s observed that the dollar feels more nervous with a large amount of volatility against the Japanese Yen (23.06%, JYVIX) and British Pound (24.34%, BPVIX).

Hence one can see that exchanges globally have experienced an unprecedented amount of volatility during the outbreak of COVID-19; still, future consequences are unknown. More significant uncertainty, more chances of market instability, the unavailability of short-selling could be one plausible reason for the increased uncertainty and volatility. Any market needs multiple lines of risk management, effective price discovery, attractive liquidity. In our recent observation on global exchanges, we find that ban on short-selling results in a higher likelihood of default, larger return volatility, abrupt stock price declines, and failure to meet policy objectives.

(Imlak Shaikh is an Assistant Professor, Accounting and Finance at MDI Gurgaon)