A 21% Chance Of A 50% Plunge In The S&P 500?

Investors' perceptions of risks, both normal (volatility) and tail (event), have intriguingly run to both extremes at the same time. 'Normal' volatility has been so suppressed by Central-Bank action as to become an almost useless indicator (or at best contemporaneous) - or as Artemis Capital notes "volatility has become a shadow currency" with the USD (safe-haven) becoming considerably more correlated with volatility. Extreme volatility concerns are where the 'unintended' consequence has appeared. In a somewhat stunning market realization, options markets currently suggest a 1 in 4.7 chance of a greater-than-50% drop in the S&P over the next year. That is more likely than the lifetime risk of a heart attack. The question then is, are tail-risks over-priced? Or are investors willing to overpay for that kind of 'deflation' insurance since we now know that the impossible is possible!

 

[look at the skew of the distribution of returns since 2008 - the light blue section - show upwardly biased it has become...]

 

and through time... the chart below shows the chart above through time, and the rise in extreme tail risk pricing since the crisis began...

 

Source: Artemis Capital Management

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