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Overview

The extraordinary growth of short volatility strategies creates risks that may trigger a serious market crash. A low-yield, low-volatility environment has drawn various market participants into essentially similar short volatility-contingent strategies with a common nonlinear risk factor. We discuss these strategies, their commonalities, and the generally unrecognized risks that they would pose if everyone were to unwind simultaneously. Volatility-selling investors essentially provide “shadow financial insurance.” Investors and regulators would benefit from preparing for large, self-reinforcing technical unwinds that may occur when/if central banks change policy or macro or political events affect investor confidence. We also discuss potential mechanisms that might provide stabilization against largely adverse financial outcomes.

About the Author(s)

Vineer Bhansali

Vineer Bhansali is the founder and chief investment officer of LongTail Alpha, LLC. His 29-year investment career started at Citibank, where he founded and managed the Exotic and Hybrid Options Trading Desk. He later joined Salomon Brothers in its Fixed Income Arbitrage Group followed by Credit Suisse First Boston in its Proprietary Trading Group. Dr. Bhansali was then at PIMCO for 16 years, serving the last 8 years as managing director and head of the Quantitative Portfolios Team, which he founded in 2008. He is the author of four books on finance, including Bond Portfolio Investing and Risk Management and Tail Risk Hedging, and has written more than 30 refereed papers on topics from option pricing to asset allocation in such leading journals as the Journal of Finance, Financial Analysts Journal, and Journal of Portfolio Management. Dr. Bhansali has received numerous awards, including the Graham and Dodd Scroll Award, and serves on the investment committee of the Margaret A. Cargill Philanthropies and on the board of trustees of MSRI and the Q Group. He holds a BS and an MS in physics from Caltech and a PhD in theoretical physics from Harvard University.

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Larry Harris CFA

Larry Harris, CFA, is Fred V. Keenan Chair in Finance at the USC Marshall School of Business, Los Angeles, and is lead independent director at Interactive Brokers.