According to a Reuters article published yesterday (October 10; see “Wall Street’s fear gauge hits record highs“),

“An index regarded as Wall Street’s fear gauge notched record highs again on Friday, reflecting unprecedented investor anxiety after the broad U.S. stock market fell in a turbulent session. The Chicago Board Options Exchange Volatility Index, or the VIX, surged 20.4 percent to an all-time high at 76.94, before closing at 69.95.”

I made reference to the VIX in my comments at the “Understanding the Financial Crisis” panel discussion on Thursday (see pp. 12-13 of “Moral Hazard and Financial Hazard”). I also reference VIX in my blog entry entitled “Volatility“. Besides being the worst 1 week period in recorded history for the major stock market indices, last week was also marked by a daily progression of new all-time highs for the VIX. Here are the closing values for each trading day last week:

Since January 2, 1990, there have been a total of 4,733 daily observations for VIX. The addition of only 5 data points last week actually marginally increased the average VIX, the VIX standard deviation, as well as the positive skewness and “fat-tailedness” of the entire data series. Friday’s closing value of 69.95 is 7.75 standard deviations to the right of the average of 19.23. If this were a normal distribution (it’s definitely not), the probability of such an extreme value would be 0.00000000000047%.

Here’s a frequency diagram for VIX during the period January 2, 1990 – October 10, 2008. (note that if you click on the graphic and look closer, the last four bars from 52 out to 70 represent the 5 closing values for VIX last week). Visually, you can see that this is a positively skewed distribution of outcomes (skewness is 1.128), and it is also fat-tailed (kurtosis is 5.22). For the normal distribution, skewness is 0 (the normal distribution is not skewed), and kurtosis is 3 (the normal distribution is not fat-tailed either). The joint effect of positive skewness and fat tails is that this means that the odds of extreme values (particularly to the upside) are higher than they would be for a normally distributed random variable. Suffice it to say, these are extremely rare events now matter how you look at them.

Tomorrow afternoon, I will take part in a panel discussion at Baylor University entitled “Understanding the Financial Crisis”. Here’s the official press release from Baylor’s Hankamer School of Business. The event will be recorded tomorrow and available for viewing on the web by by no later than Oct. 20, 2008.

Anyway, here’s the line-up:

Moderator: Dr. Mark Dunn, Professor of Marketing and Associate Dean, Hankamer School of Business

Panel:

• Dr. Gia Chevis, Assistant Professor of Accounting

• Dr. James Garven, Frank S. Groner Memorial Chair of Finance and Professor of Finance & Insurance
  “Moral Hazard and Financial Hazard”

• Dr. Kent Gilbreath, E.M. and Thelma Stevens Chair of Private Enterprise and Entrepreneurship and Professor of Economics
  “The Perfect Economic Storm”

• Dr. William Reichenstein, Pat and Thomas R. Powers Chair of Investment Management and Professor of Finance
  “Investment Advice in Credit Crisis”

• Dr. David VanHoose, Herman W. Lay Chair of Private Enterprise and Professor of Economics

Here’s a time series graph of the CBOE volatility index (VIX) from January 2, 1990 through October 8, 2008:

Today, the VIX today hit an all-time high of 57.64 (after hitting all time highs of 52.05 on Monday and 53.68 on Tuesday). Since the mean of this series is 19.21 (based upon a total of 4,730 daily closing prices dating back to January 2, 1990), and its standard deviation is 6.47, today’s VIX is 5.94 standard deviations to the right of the mean. Obviously this is a very fat-tailed distribution, but it is nevertheless (morbidly) entertaining to point out that if the series were normally distributed, then one would expect to observe this extreme of an outcome once every 683,138,010 days that the financial markets are open. The number of trading days varies from year to year depending on what day of the week holidays fall on, but a rough guess is 52 weeks x 5 days per week = 260 less about 10 holidays = 250 trading days. So if we translate this into the implied number of years, the odds of this happening would come out to roughly once every 683,138,010/250 = 2,732,552 years.

Intrade yesterday announced a new binary futures contract, which pays off 100 Intrade points ($10) if the US economy suffers a depression sometime during 2009, and 0 Intrade points ($0) if it doesn’t. “Depression” for purposes of this contract is defined as a total decline in GDP equal to or greater than 10%. See http://www.intrade.com/news/news_288.html for specifics on the contract rules. The ticker symbol for this contract is US.DEPRESSION.09. The “good” news is that so far, no trades have occurred; there is a bid price of 5, and an ask price of 15.

Perhaps the more meaningful contracts are the US.RECESSION.08 and US.RECESSION.09 contracts, which represent (100,0) bets that the US economy suffers a recession sometime during 2008 or 2009. Both contracts define recession as two successive quarters of negative real GDP growth. The last trade for US.RECESSION.08 occurred at 50 and at 80 for US.RECESSION.09, but compared with the political contracts, trading volume is quite low and bid-ask spreads are very wide, which implies these contracts are relatively illiquid. For example, for US.RECESSION.09, there currently are bid prices ranging from 10 to 75, and ask prices ranging from 80-99.9.

Media Contact: Cynthia Jackson

254-710-7628 (office)

254-749-4055 (cell)

Cynthia_Jackson@baylor.edu

PANEL OF EXPERTS TO DISCUSS

FINANCIAL AND MORTGAGE CRISIS

WACO, Texas – Five professors from Baylor University’s Hankamer School of Business will provide perspectives and advice about the current financial and mortgage crisis facing the United States. The panel discussion will take place on Friday, October 9, from 3:30 to 5:00 pm in Kayser Auditorium.

“Several faculty felt that we could offer students some valuable perspective and analysis on the current economic situation,” said Dr. Tisha Emerson, associate professor and associate chair of the Economics department. Emerson is coordinating the event. “This will be an opportunity for them to hear analysis from the experts and get answers to their questions.”

Panelists include experts in various aspects of economics, finance, accounting and insurance. Each will speak to a different aspect of the crisis and then answer questions from the audience.

Dr. Gia Chevis, assistant professor of Accounting, will discuss “mark-to-market” accounting procedures. Mark-to-market accounting became widely adopted as a practice in the 1980s and 1990s and impacts how an asset’s value is calculated. Mark-to-market is a practice specifically addressed within the bailout legislation recently passed by Congress.

Dr. James Garven, professor of Finance and Insurance and holder of the Frank S. Groner Memorial Chair in Finance, will focus on moral hazard related to bailouts. He will discuss some obvious examples of the risk of unintended consequences, including Fannie Mae and Freddie Mac.

Dr. Kent Gilbreath, professor of Economics and the holder of the E.M. and Thelma Stevens Chair of Private Enterprise and Entrepreneurship, wrote presciently of the economic crisis more than a year ago. He will discuss the origins and causes of the crisis and its impact on the economy.

Dr. William Reichenstein, professor of Finance and holder of the Pat and Thomas R. Powers Chair of Investment Management, will provide commentary about what investors should do now and how the crisis might affect investor portfolios and savings plans.

Dr. David VanHoose, professor of Economics and holder of the Herman W. Lay Chair of Private Enterprise, will talk about the “blame game.” Does any one person, group or decision bear responsibility for the crisis?

The event is free and open to all Baylor students, regardless of major.

For more information, contact Dr. Tisha Emerson, Tisha_Nakao@baylor.edu, 710-4180.

About Baylor Business

The Hankamer School of Business holds to a visionary standard of excellence whereby integrity stands shoulder to shoulder with analytic and strategic strengths to build leaders, not simply careers. BusinessWeek ranks the program in 36^th place. U.S.News & World Report ranks the undergraduate business program in 58^th place. Baylor’s Entrepreneurship program is ranked 14th by U.S.News and its Accounting program is ranked 24th by Public Accounting Report. Visit www.baylor.edu/business for more information.

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I just checked on the weekly return series on the SP500 dating back to January 1950, and I found that in the 3,065 weeks in this series, the % change in the S&P 500 during the course of this week (-9.4% from last Friday through today) is the fourth worst on record. The only weeks that were worse during this period were the week of the crash of ’87 (-12.2% net, inclusive of the more than 20% decline on “Black Monday (October 19)), the week leading up to 9/11 (-11.05%), and the first week of April 2000 (-10.54%).

How’s this for pessimism? According to October 13, 2008 issue of Business Week, we have now officially entered the “New Financial Ice Age”!

TIME, “Sky High Housing”, 09/12/1977

TIME, “To the Rescue” 11/13/1978

BusinessWeek, “The Death of Equities”, 08/13/1979

TIME, “The Squeeze of ‘79”, 10/22/1979

TIME, “The Computer Moves In”, 01/03/1983

TIME, “That Monster Deficit; America’s Economic Black Hole”, 03/05/1984

TIME, “The Crash”, 11/02/1987

TIME, “Is Government Dead?” 10/23/1989

BusinessWeek, “Is the Party Over?” 04/17/2000

TIME, “Will You Ever Be Able to Retire?” 07/29/2002

Today, it appears that the U.S. Senate is doubling down on the bill that the U.S. House of Representatives rejected on Monday. I am sure not how effective or meaningful higher FDIC insurance limits are likely to be; the bill calls for, among other things, raising the upper limit from $100,000 to $250,000 on insured deposits. Clearly, such a policy change weakens incentives for consumers to monitor their banks and also makes it incumbent upon banking regulators to monitor more solvency even more closely. By increasing the upper limit on coverage, this is an indirect way to recapitalize banks in the short run (by effectively enabling them to substitute (contingent) government capital for private capital). However, this also carries with it a serious moral hazard by creating incentives for banks to rely less upon private capital in the longer run.

I couldn’t help but notice from the news reports today that one senator apparently managed to slip in a provision in the “bailout” bill for “mental health parity”, whatever that means. I think it has something to do with mandating more “generous” mental health coverage in the private health insurance markets. What this measure has to do with resolving the credit crisis is beyond me. I can’t help but wonder what other completely unrelated earmarks are being inserted as a way to buy votes.

Morningstar’s Pat Dorsey gives his take on the market plunge today, based upon the extreme values being realized these days by the so-called “VIX” index: