The turns of the SKEW: black swan protection at a premium

February 2016 | FEATURE | RISK MANAGEMENT

Financier Worldwide Magazine

The catastrophic consequences of a black swan event, much feared throughout the corporate world, have now become even more expensive to protect against thanks to the CBOE SKEW Index – that all knowing, all seeing measurer of the tail risk of the S&P 500 – recently hitting an all-time high.

Devised by the exchange behind the VIX Volatility Index (that is, the Chicago Board Options Exchange (CBOE)), the SKEW is a benchmark measure of the perceived risk of extreme negative moves in US equity markets.

The SKEW, complemented by the VIX, is one of more than a dozen volatility-related benchmarks and strategies formulated by the CBOE, often referred to as the home of volatility indexes. It offers an important measure for investors who are concerned about potential market moves driven by unusual, high-impact events. “A valuable tool to add to our rapidly growing suite of volatility benchmarks,” attests William J. Brodsky, CBOE chairman and CEO.

Whereas the VIX captures the market’s expectation of likely daily S&P 500 returns over a 30-day time horizon (falling within one standard deviation around the average, or ‘mean’ return of the S&P 500 price distribution), the SKEW, in comparison, focuses on the tail risk of the distribution – S&P 500 returns that are greater than two to three standard deviations below the mean.

“Essentially, the SKEW surge has spooked the stock market.”

It is these SKEW values, typically ranging from 115 to 135, which are calculated from weighted strips of out-of-the-money S&P 500 options, that have now hit an all-time high, indicating that investors are more fearful than ever of a black swan event coming to pass.

Risk and expectation

According to the CBOE website, a reading of 100 means that the probability of a black swan event is “negligible”. At 115, there is considered to be a 6 percent risk. At 135, this becomes a 12 percent risk. Therefore, a reading of 148.98 (or more) on the SKEW Index indicates that the risk of a black swan event is now higher than it has ever been.

Whilst higher SKEW values means that protection against an unexpected event of large magnitude and consequence is indeed more costly, perhaps perversely, this does not equate to the likelihood of a black swan event taking place being any higher, although the implication is certainly there.

Analysts at the Bespoke Investment Group have attempted to explain this apparent contradiction, stating that “the SKEW measures the relative price of ‘tail risk’ hedges versus broad volatility” and should be considered in the context of markets that are prone to experiencing large dislocations.

All-time-high

With the SKEW at an all-time-high and uncomfortably reflecting the increased fear among investors as to the risk of a black swan catastrophe, the question to be asked is what is accounting for this escalation in the measurement of fear? As it happens, a great deal of the anxiety can be laid at the door of weak economic growth in China, the world’s second-largest economy. China’s economic deceleration can be exemplified by its official growth rate of 6.9 percent, a six-year low. SKEW levels have also been fuelled by speculation over an interest rate rise from the Federal Reserve, continuing geopolitical concerns around Russia and the Middle East, not to mention the disappointing growth pervading the global economy.

Tense traders?

With the CBOE stating that the probability of a black swan event is indicated by a drop of more than two standard deviations, it is illuminating to learn how the market has responded. According to Roberto Friedlander, head of equity trading at Brean Capital, traders are “pricing in the highest chance of an outlying black swan event in the next 30 days”, with current pricing reflecting “a 15 percent chance of a two standard deviation move in the next 30 days”.

Less concerned as to the SKEW’s indication of an elevated risk of an outlier event is Dana Lyon, a partner at J. Lyons Fund Management. “The fact that it hit an all-time high is a trivial matter when comparing the reading versus other high readings historically,” he says. “We have used 140 as the line of demarcation for ‘high’ SKEW readings. Thus, the fact that it hit 148 instead of, say 145, is of no consequence.”

Conclusion

Clearly, the substantial increase in the SKEW Index, the highest it has ever been in its 25-year history, is causing significant ructions for traders. Indeed, the ‘Flash Crash’ in 2010 was preceded by an extremely high SKEW reading. Given the SKEW’s status as a remarkably accurate and effective volatility benchmark, this may well have an ill-effect on the market. Essentially, the SKEW surge has spooked the stock market and reinforced the belief among market participants that, if you truly want to feel safe amid the spectre of a black swan event, then paying up to attain a degree of security is pretty much the most logical thing to do.

Fraser Tennant