Investors may be taking too many risks in over-priced markets because they are underestimating potential volatility, warns the Bank of England's risk chief.
Measures of volatility are low because investors can buy insurance cheaply – but Alex Brazier said that is akin to driving more dangerously because car insurance costs have come down.
"Measures of actual and implied volatility are often used as an indicator of risk to inform investment decisions. When they're low, the world appears less risky, so less compensation appears to be needed for risk," said Brazier, the Bank's executive director for financial stability strategy and risk.
"The trouble is that these are not measures of risk. They are a reflection of the risk appetite of those selling insurance. Taking on more risk because implied volatility is low is the equivalent of ignoring the road conditions and driving faster because your insurance got cheaper as a herd of new entrants flooded the car insurance market."
This could be building up problems for the future, he said.
"When accidents start to increase, the whole thing can go into reverse. Those who had been selling insurance can incur losses. What might have looked like a profitable insurance business won't do so any more," he said in a speech at the Brevan Howard Centre for Financial Analysis at Imperial College Business School.
"The terms on insurance can shift abruptly. The result: driving speeds slow down to a snail's pace. In markets, this means price adjustments, whatever triggered them, might be followed by sharp withdrawal of cheap insurance, which removes the need for dealers to act as a stabilising influence – leading to greater market volatility and sharp reduction in risk appetite. Market moves are amplified."
The Bank of England is investigating the potential risk posed by this apparent and misleading fall in volatility measures.
Its Financial Policy Committee has commissioned a review of the use of these derivatives, he said.
Taking on more risk because implied volatility is low is the equivalent of ignoring the road conditions and driving faster because your insurance got cheaper.
Brazier also warned that bond markets may be vulnerable to a crunch, if open-ended funds – which are now big buyers of bonds – have to offload bonds rapidly.
A lack of investment bank trading and warehousing of bonds may mean there is too little liquidity available to absorb large moves, leading to rapid falls in prices.
"It's possible that just as corporate bond markets have become less liquid, they may have become susceptible to greater selling pressure after a shock," Brazier said.
"We may have more of a mismatch of liquidity. That could amplify any price adjustment."
The use of open-ended funds, which typically give quick access to investors who want their cash but cannot sell their own assets instantly, presents more risks.
"If a fund is selling assets in timeframes shorter than typically needed to obtain the market price, then redemptions result in a transfer of value to redeeming from remaining investors. When investors think others might redeem, they might face an incentive to run to the exit," he said.
"Unless it can be corrected through appropriate pricing arrangements in the fund, this structure might create an advantage to getting out first. Existing 'swing pricing' arrangements go some way to doing this but may not be sufficient to correct it fully."