Global Equity Derivatives December 1999 Global 20th Century Volatility Equity Research 120 South Sea Bubble Repeal of Bubble Act of 1720 100 Great Depression Oil Crisis 80 60 Historical volatility (%) Civil War 40 WDR Research is available electronically on the following: Bloomberg, First Call, IBES Trapeze, Multex, Research Direct and our 20 web site: www.wdr.com/researchweb Warburg Dillon Read is the 0 investment banking division of 1700 1750 1800 1850 1900 1950 2000 UBS AG FT All Share S&P 500 Source: WDR Alexander M Ineichen CFA A review of the stock and +44-20-7568 4944 [email protected] derivatives markets in the 20th Century 20th Century Volatility December 1999 Contents Page Alexander M Ineichen Introduction......................................................................................................3 +44-20-7568 4944 Prologue to the 20th century ...........................................................................4 — Volatility since Divine Comedy......................................................4 Markets in the 20th century...........................................................................12 — Overview .....................................................................................12 — Stock market risk and return in the 20th century ........................18 Derivatives in the 20th century......................................................................47 — Prologue to the 20th century.......................................................47 — Derivatives in the 20th century....................................................50 — The 1970s: The beginning ..........................................................52 — The 1980s: Start of the bull run...................................................59 — The 1990s: Continuous growth ...................................................69 — Volumes overview by market ......................................................75 Why have derivatives become popular .........................................................79 — Derivatives: A growth story .........................................................79 — Attractive characteristics .............................................................81 Why have derivatives become unpopular .....................................................84 — The negative image of derivatives ..............................................84 — Chronology of derivatives disasters ............................................85 — The myth of derivatives ...............................................................89 Use of derivatives today................................................................................93 The next 100 years........................................................................................96 — Risk management .......................................................................96 — Equity premium ...........................................................................98 — Forecasting..................................................................................98 — Internet stocks...........................................................................100 — Investment management...........................................................101 — Trade wars ................................................................................101 — Political risk ...............................................................................102 — Information risk..........................................................................103 — New technology: New uncertainty.............................................104 Appendix......................................................................................................105 References ..................................................................................................109 2 Warburg Dillon Read 20th Century Volatility December 1999 Introduction The 20th century has been a turbulent time for equity investors. This report is a review of equity volatility and its instruments – the instruments which allow investors to deal with volatility, ie, derivatives. We intend to make this a regular publication. Please find the next issue on your desk in December 2099. This report is slightly In our derivatives research efforts we try to be to the point but thorough, focused different from our usual without a lack of the big picture. We focus on economic and statistical significance equity derivatives research as opposed to anecdotal evidence. This report is different: it is neither to the point publications nor thorough and is to a large extent anecdotal. Since we dive into the subject best described as ‘financial anthropology’, an approach covering every economically and statistically significant aspect of risk and derivatives over 100 years would most likely exceed the attention of the casual reader during the festive season. This self- imposed restriction means we will not be covering many exciting topics related to risk and derivatives, such as “bivariate generalised autoregressive conditional heteroscedasticity-in-mean studies of the relationship between return variability and trading volume in international futures markets”. This, obviously, is a loss to the reader, for which we would like to apologise up-front. In the first section we will be looking at volatility in equity markets in the 20th century, starting with a prologue covering the volatility of UK price inflation since 1300 (AD) and UK stock price volatility since 1700. The subsequent section summarises some aspects in the history of derivatives. In the next two sections we raise two questions and some attempts to answer them: (1) Why have derivatives become so popular? (2) Why have derivatives become so unpopular? We conclude the report with an outlook for the next 100 years. If our predictions do not materialise until the next derivatives century-review is due, the author will take full responsibility. Our conclusions are intended to be thought provoking. Some readers, however, might regard them as fatuous or even ludicrous – probably as fatuous and ludicrous as a rational economic agent viewed the contemporary in December 1899 who stated that inflation would top 10,000% in Berlin and the conversion of Karl Marx’s theories into the real world would cost 100m lives during the next 100 years. The author would like to thank Alan Scowcroft, Mike Duff, Scott Mixon and Heinz Kubli for their contributions to this report. The Warburg Dillon Read equity derivatives research team wishes you a pleasant holiday season. 3 Warburg Dillon Read 20th Century Volatility December 1999 Prologue to the 20th century Volatility since Divine Comedy The experience of price The concept of volatility and the management of uncertainty were not new to the changes is not a 20th century. Probably the most ancient volatility experienced by mankind is that of phenomenon of asset prices in general, ie, the interchange of inflation and deflation. Apparently, modern times prices shot up in ancient Babylon between 1740 and 1700 BC by three-and-a-half times and the price of donkeys rose eightfold in Roman Egypt around 200 AD. Fluctuations in prices, uncertainty and the management of risk have caused headlines during the 1990s. Volatility and the management thereof is not new – neither conceptually nor instrumentally. Before we take a closer look at equity volatility in this century we go back in time and look at how equity volatility would have been if stocks had been around for the past 700-plus years. Since the Middle Ages, In the search for such rather long-term data, we found consumer price data for the there has been a long term UK starting in 1264, ie, when Dante Alighieri was born, who later wrote Divine trend of falling volatility Comedy – perhaps the greatest literary expression of the Middle Ages. Since in this century extreme deflation (1930s) and inflation (1970s) were associated with high volatility in equity markets, one can assume that had equities been around in the 13th century, the volatility of consumer prices would, to some extent, be correlated with the volatility in equities. Chart 1 shows the rolling 20-year volatility of yearly changes in UK consumer price inflation between 1300 and 1999. We have used UK consumer price volatility as a proxy for equity volatility. Chart 1: Volatility of consumer price inflation since 1300 AD 25 20 15 10 Volatility of UK inflation (%) 5 0 1300 1400 1500 1600 1700 1800 1900 2000 Source: WDR (data from Global Financial Data) 4 Warburg Dillon Read 20th Century Volatility December 1999 Most extreme fluctuations A comforting fact for market participants hit by increasing equity volatility in 1997 were in the 20th Century and 1998 is that the long-term trend of volatility is down. As we will point out later, the 1990s were a decade of low volatility – at least in a long-term context. With a long-term perspective the world has become a less volatile place. On the other hand, the most extreme price changes within 5,000 years of written human history of 10,000% in Berlin in the 1920s or 600% per month in Argentina in the late 1980s were in this century. Chronology Europe – 13th century: On one hand, the 13th century can be described as “volatile” where volatility was Jenghiz Khan increases event driven. On the other hand, trade and prosperity rose to their highest medieval volatility and French level (Homer 1996). Mongol conqueror Jenghiz Khan conquered most of the Chin wine is discovered empire of north China, subdued Turkistan,