66 Finance & economics The EconomistFebruary 15th 2020
2Buttonwood Eyeing the storm
SavedbythebellcurveSource:TheEconomistDistributionofoutcomesforrollingtwodice(^3) / 36 3 / 36
(^1) / 36 1 / 36
(^2) / 36 2 / 36
(^6) / 36
(^4) / 36 4 / 36
(^5) / 36 5 / 36
234567
Sum
8910 11 12
E
very stonerknows, or has bored you
silly, about the third eye. It is the
imaginary oracular organ you develop as
a side-effect of taking hallucinogens. The
data from hazy late-night discussions in
college dorms in the 1960s are quite clear
on this. The strait-laced are too middle-
of-the-road to grasp what is really going
on in the world. The third eye allows you
to see what they simply cannot.
Every investor could use a third eye.
But there is one type who can claim to
need it the most: options traders. They
have to keep one eye on the most likely
outcome and one eye on each of the best
and worst scenarios. A lot of the time, the
middle outcome—the average, the mid-
point, the most common—is a good
predictor. But for some things, some of
the time, the middle lies on shaky
ground. This is the world in which hav-
ing options—or the right to buy or sell
assets at a predetermined price—is most
valuable. And the action that matters is
not in the middle but at the fringes.
To understand why, imagine you had
to bet on the height of the next man to
walk into the coffee shop you are sitting
in. A good guess would be 1.75m (5ft 9in),
which is the average height of an adult
male in America. It is likely that you
would be wrong, but not by a whole lot.
Many of the men who could walk in will
be close to average height; very many will
be an inch or two below or above it; and
only very few will be a lot shorter or
taller. The middle—the average—is a
good predictor of how something entire-
ly random will turn out.
A throw of two dice is similar. There
are 36 possible pairs of numbers. Some
throws are more likely than others: there
are six ways to throw a seven, but only
one way to throw either a two or a 12. If
you display each possible throw by how
often it occurs, it will follow the outline of
a special kind of bell curve, known as a
normal distribution (see chart). A lot of
very different kinds of measures—iq,
exam scores, height—also look like this. A
feature is that the values deviate from the
average in an ordered way. Two-thirds of
dice throws (24 out of 36) are within one
standard deviation of the average throw, ie
within a range of five to nine. In a normal
distribution, 68% of outcomes are within
one standard deviation of the average and
95% are within two.
The standard deviation—volatility—is
a key concept in options trading. The vix,
or volatility index, is the best-known
gauge for it. It is the level of volatility
derived from the price of options on the
s&p500 share index. (Put options confer
on a buyer the right to sell the index at a
specified “strike” price; call options confer
the right to buy it.) Key inputs to the value
of an option are expected volatility and the
gap between the strike price and the index
price. The more violently prices move, the
more likely the gap between the two will
be bridged—in which case the option
pays off. If the vix says that implied
volatility is 14, as it does now, traders
expect an annual standard deviation of
14% in equity prices.
The level of implied volatility de-
pends on the weight of buyers and sell-
ers. Vol sellers in effect supply insurance.
They are betting on the middle, that the
world will stay regular and normal, or
become more so. People active in the
options market describe all investment
strategies as if they were options trades.
To buy corporate bonds with low spreads,
for instance, is like selling volatility: you
get a low premium and cross your fingers
it doesn’t default. Vol buyers, in contrast,
seek insurance. They don’t believe the
middle. They think the world will be-
come more disordered. And sometimes
they are right. Asset prices are not dis-
tributed in as ordered a way as height is.
Extreme events, such as market crashes,
are more frequent than normal dis-
tributions suggest. Volatility has been
remarkably low—in stocks, bonds and
currencies. Viruses, populism, trade
wars, papal abdications and royal bust-
ups—nothing seems to move the needle
much. But no one can be sure how long
the age of placidity will last.
People with squeegee-cleaned third
eyes insist that vol must eventually go
up. They blame central banks, which
have relaxed monetary policy whenever
markets panic, for suppressing volatility.
The central bankers have been free to do
so because inflation, their main obses-
sion, has gone missing. A revival in
inflation will one day force them to stop
managing the markets. That is the big bet
of options buyers. In the meantime, the
standard investor will keep his two eyes
firmly on the middle.
Looking at the world through the eyes of options traders
and fuel. Those are mostly consumed by
city folk, who are more prone to protest
than those in the countryside. Inflation
hits industry, too. Nigerian firms buy much
of their machinery and inputs from abroad
and so are hurt by higher import prices,
says Segun Ajayi-Kadir, the director-gen-
eral of the Manufacturers Association of
Nigeria. Ethiopian factories import about
half of their raw materials. Garment firms
ship in fabric; shoemakers, leather.
Left unchecked, inflation erodes any
boost to exports. Consider a 10% deprecia-
tion in the “nominal” exchange rate—that
is, the rate advertised in newspapers or at a
bureau de change. If domestic prices also
rise by about 10% then there is no change in
the “real” exchange rate, which measures
relative prices of domestic and foreign
goods, and that is what counts. In practice
prices rarely jump that much: in 2012 imf
researchers estimated that in sub-Saharan
Africa a 10% depreciation typically results
in domestic price rises of only 4%. But to
maintain an undervalued real exchange
rate, governments would have to limit in-
flation by containing local demand, for ex-
ample by trimming public spending, notes
Abebe Aemro Selassie, the director of the
imf’s Africa department. As this is difficult,
countries do not typically contemplate
strategic undervaluation.
Perhaps this is not a surprise. Much like
tackling corruption or fixing the myriad
other problems African economies face,
strategic undervaluation is hard to pull off.
It imposes real wage cuts on the workforce,
notes Christopher Adam of Oxford Univer-
sity, so “you’re imposing the cost on cur-
rent workers and consumers for the benefit
of future generations.” No wonder politi-
cians prefer their exchange rates strong. 7