V is for Volatility

July 27th, 2014 at 10:00 am by David Farrar

Just five to go:

would be a pale imitation of itself without volatility, or at the very least about as stimulating as watching paint dry. Luckily the world is a complicated place, where prices fluctuate for various reasons, and this, for the most part, is a good thing.

On a microeconomic level, producers wouldn’t be able to discover demand if there was no volatility. Volatility is indeed an essential ingredient for commerce to exist, with entrepreneurs engaging in a process of arbitrage between the price at which they buy inputs and the price at which they sell output. Furthermore, there would be no way of allocating scare resources to their most efficient use if we didn’t have price movements to guide the market.

Price changes are also needed to encourage investment in a particular sector. Long-term trends in commodity prices, such as Asia’s growing demand for protein, tell farmers that the investment needed to convert their land to dairy pasture is likely to payoff in the end (though not guaranteed).

Although price fluctuations usefully steer production and investment, this doesn’t mean all types of volatility (or lack thereof) are equally desirable. The effect of politics on markets can stifle or increase volatility completely separate from fundamental price drivers.

International debt markets are a good example. The yield on 5-year Greek government bonds has been trading at a fairly consistent level of just over 4 percent for some time. Meanwhile Argentinian 4-year bonds (the closest comparable security) are trading at 7.6 percent. The difference has almost nothing to do with economic fundamentals, since both countries are in major financial strife. 

An investor, who knew nothing about the political support being lent by the European Union, might conclude from the yields that Greece is responsible with its public finances compared to Argentina. In actual fact Greece’s public debt to GDP stands at 161 percent, whereas Argentina’s public debt is equivalent to 42 percent of GDP.

The opposite can also be true. Investors in New Zealand’s listed electricity sector know only too well how volatile share prices have been due to the Labour and Green’s proposal to restructure the market, when in actual fact the fundamentals of the industry haven’t really changed.

To conclude, change, or volatility is a good thing in economics, provided it is based on market fundamentals and not political hot air.

Next week is Welfare!

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4 Responses to “V is for Volatility”

  1. Mr_Blobby (164 comments) says:

    The problem I have with markets, is that there seems to be smart money (in the know) and dumb money (buying in at the top of a bubble).

    There seems to be no such thing as a FREE market, everything is being manipulated, interest rates, exchange rates, Gold, Libor etc

    Bubbles are allowed to inflate to a point were it is blatant that there has been a disconnect between asset prices and reality, and still people are out there pumping it higher.

    Credit agencies give some one a AAA rating the next day they are bankrupt, and we are expected to believe that nobody saw it coming.

    Same with economic crisis, all we here in the news is that everything is fine, then out of nowhere we have an economic crisis.

    Economists are the worst their so called expert opinions are more wrong than right and they are supposed to be the so called experts.

    The average person is very unaware of what is happening around them, there are just to many irrelevant distractions.

    Mark my words this will all end very badly.

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  2. Mr_Blobby (164 comments) says:

    The pressure from the markets for the likes of, a scheme that is compulsory and locked in like Kiwi saver, is growing. In a pyramid Ponzi scheme (financial markets) there is a requirement for more money to be feed in at the bottom to keep the scheme afloat.

    It is a bit like musical chairs sooner or latter the music stops, and somebody misses out.

    At some point the next economic crisis will come along and even if you see it coming and want to get out you will be locked in.

    How many people saw there retirement saving halved or wiped out, just before their retirement during the last 3 economic crisis’s I have witnessed.

    The last has to be the worst in that not one person was held to account for it. Not one Bankster was held accountable.

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  3. thor42 (971 comments) says:

    Very much looking forward to the “W is for Welfare” article!

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  4. OneTrack (2,981 comments) says:

    “How many people saw there retirement saving halved or wiped out, just before their retirement during the last 3 economic crisis’s I have witnessed.”

    How many can see their Kiwisaver wiped out if Winston gets in and uses it to buy back the “assets”. Assets ™ which will be operating in a price controlled environment ie losing money.

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