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Volatility Risk

May 31, 2013

Essay. “Volatility risk” is not an “investment risk”. It is just “volatility” and reflects exactly the price-making activity of both investors (of whom we need to say more about) and the “market makers” or “floor traders” who populate the trading floors or promulgate their computers with quick-thinking programs (Reuters, May 31, 2013, NYSE asks SEC to reinstate volatility curbs).

“Volatility” is the opportunity for arbitrage between bid and ask prices and the supply & demand for buying and selling a stock, or stocks; and the people who are closest to the action and have the best chance to make arbitrage profits – which are a sure thing – are the broker/dealers, their floor traders, some of whom are independent and work only for themselves, and the investment banks who might be dealing in large blocks of stocks worth many tens of millions that have to be bought or have to be sold because somebody needs the cash (or bonds, right away) or somebody has the cash (or bonds, too hot to handle) but wants the stock.

“Volatility risk” is, therefore, not a “random walk”; nor is it a “diffusion process”; and anyone who is making an investment decision on the basis of the known or demonstrated volatility – which is the up and down price movements of stocks, short term or long term – is “walking backwards” and might be “surprised”. Which goes to figure but seems to be news to legions of investors who are looking for enlightenment in what happened yesterday and are playing it back now in the hope of some profits that have not already been arbitraged away.

For most investors, the “pickings” will be pretty thin because after the traders, there are the “micro-arbitragers” who are relying on super-fast computers located in apartments close to the trading floors; and after them, the “day-traders” who are punting in the morning from home and closing out by the end of day, lest they be embarrassed by a late night call.

And then we have the “big picture” guys who can really move markets and are using the Capital Assets Pricing Model (CAPM) and Modern Portfolio Theory (MPT) to replicate some benchmark, most typically, a “market index” such as the Dow Jones Industrial Average, at which they routinely fail, although they might also try to explain why we would want to buy an “index” when we should be buying an “investment” – something for which we might reasonably expect a non-negative real rate of return.

For a real clear view of how far – aka bizarre – this has gone, we suggest one the best Indices which has something for everyone, and from everyone who is in this business, and is a wonderland of statistical technology and “risk premia” ripe for harvesting, day and night, season after season. By all means, get the fallen fruit and leave nothing else to chance.

It might be possible to take a longer view and think that what we want from our investments is 100% capital safety and a hopeful return above the rate of inflation, which can be described more succinctly as “the possibility of a non-negative real rate of return”. Although it sounds to be an unambitious plan, it is, in fact, very aggressive – very aggressive – because we are leaving nothing to chance and have no fear.

One might say that “risk averse” investing is all alpha in a beta-market artificially driven by fear, anxiety, and the necessity of trading profits on Wall Street.

Investment Risk

The Pilgrim’s Progress

At “investment school”, we were presented with a clear diagram of “investment risk” but the “summit” is actually the least risky and the “base” is actually the riskiest.

For example, undoubtedly our government bonds will mature and give us back our money, but what’s the money worth if we have no control or say in inflation?

Or consider the plight of the T-bill investor at 50 basis points and today’s T-bill rate is 75 basis points; this poor lad just lost 50% of his return because he can’t sell his 50-basis point T-bill for less than the 75-basis point T-bill, and will have to make up the difference in cash, if he needs cash, which really mounts up for the banks and insurance companies who are buying and selling face amounts of $1 billion on a typical day – else what is the trading desk for?

After “investment school”, we went to the Harvard School of Business Management and we were required to learn an enhancement to our understanding of “investment risk”.

And after Harvard, we went to Wall Street and really learned what it was all about.

The Price of Risk

The calculated Risk Price (SF) is a provably effective estimate of the “price of risk” which is “the least stock price at which the company is likeable” (Goetze 2009) and “likeability” is determined by the demonstrated factors of “risk aversion” – we want to keep our money and obtain a hopeful return above the rate of inflation – and the properties of portfolios of such stocks.

Stock prices that are less than the price of risk can be said to be “bargain prices” but with the risk attached that the company might never get a higher price other than that due to ambient volatility or “surprise”; on the other hand, investors who are willing to pay the “full price” above the price of risk, and buy and hold the stock at those prices, must also be confident, and have reason to believe, that the company will produce those values, absent new information.

Please see our Posts, The Price of Risk, August 2012 and The Nash Equilibrium & Its Stock Price, October 2012, for more information on the theory.

To see what else “risk averse” investing can do for us, please see our recent Posts, The Wall Street Put, April 2013, and earlier Posts such as The Dow Transports, March 2013, or The Risk Adjusted Dow, March 2013, or The Canada Pension Bond, February 2013, and for a more colorful description of investment risk and the application of the “price of risk” to mergers & acquisitions, please see our Post, Bystanders & Collateral Damage, April 2013.


We are The RiskWerk Company and care not a jot for mutual funds, hedge funds, “alternative investments”, the “risk/reward equation” and every other unprovable artifact of investment lore. We have just one product

The Perpetual Bond
“Alpha-smart with 100% Capital Safety and 100% Liquidity”
With No Fees and No Loads on Capital

For more information on RiskWerk, please follow the Tags or Categories attached to this Letter or simply enter Search for additional references to any term that we have used. Related data may be obtained from us for free in a machine readable format by request to


Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”. Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability. We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now. The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”, ”price of risk”, “risk price”, and the symbols “(B)”, “(N)” and N*.

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