In a March 2007 interview, Nobel Laureate Myron Scholes presciently notes, “My belief is that because the system is now more stable, we’ll make it less stable through more leverage, more risk taking (italics added for emphasis).” In a December 2006 WSJ article entitled “The Risk Business”, it is noted that risk premiums seemed at the time to have been “drained” out of whole classes of financial assets. The article goes on to suggest that the reason for this was because advances in financial innovation (in all its various forms, including the buying, selling, swapping, trading and securitization of risk) had actually made the financial markets safer for investors; consequently risk premiums up to that point in time had fallen substantially.
One way to measure the overall degree of “safety” in financial markets is to look at the CBOE volatility index (aka “VIX”). Here’s what the time series looks like for this index starting December 1, 2006 (around the time that the WSJ article “The Risk Business” was published) up to yesterday. The best way to think about it is that it measures “consensus” forecasts of future (U.S.) stock market volatility as reflected in the market prices of call and put options written on the S&P 500 index. The higher the value for VIX, the more risk averse investors are in the aggregate. What’s interesting about this time series is that at the time that Scholes’ interview was published (March 2007), forecasted stock market volatility (specifically, expected annualized volatility) had rather dramatically increased nearly twofold in a matter of a few days, going from around 10% to 20% (putting this into perspective, the long run average value for VIX, going back to January 1990, has been around 19%, so this really reflects more of a mean reversion effect). However, since July 2007 (and within the last week in particular), this data series has undergone a substantial increase in terms of its level as well as the “volatility of volatility”, as you can see in the graph below:
These data provide an important context for Scholes’ quote. The “dark side” of innovations in risk management is that they often encourage offsetting risky behaviors (e.g., as in the development over time of the subprime mortgage market); as Scholes noted, these offsetting behaviors came in the forms of more leverage and more risk taking. This is an important example of “moral hazard” in the real world, and it is commonly referred to as the “Peltzman” effect (named after economics Prof. Sam Peltzman at the University of Chicago).