December 1, 2021

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Risk Is Misunderstood by Many Investors, Says VIX Pioneer

(Bloomberg Markets) — Volatility has always been a feature of markets. In a 1989 research paper, Dan Galai, along with Menachem Brenner, proposed creating an index—which they called Sigma—to track the volatility of stocks. That research eventually helped inspire Chicago Board Options Exchange (now Cboe Global Markets Inc.) to create the VIX, known as Wall Street’s “fear gauge.” (There remains disagreement over how much credit their research deserves for the index.) Born in Jerusalem, Galai earned his Ph.D. at the University of Chicago before embarking on a career that included serving as dean of the Hebrew University of Jerusalem’s business school and founding Sigma Investment House. In April he spoke to Bloomberg about his career, the research around volatility, and what interests him today.

Yakob Peterseil: What sparked your interest in finance?

Dan Galai: I got my undergraduate degree in economics and statistics. When you engage in statistics and economics, you have the basic tools to deal with uncertainty. For my master’s degree, I was very much interested in papers on portfolio selection, on the capital asset pricing model, on the whole issue of selecting and balancing portfolios. At the same time, I was also doing my master’s thesis on the pharmaceutical industry and their investment decisions—the uncertainty of developing new drugs and launching new products in the medical field. I define myself as having two heads. Financial innovation and technological innovation. On top of both of them is dealing with uncertainty.

YP: How important was Chicago for your work?

DG: Extremely important. I went to six to seven workshops a week. The discussions that went on were amazing. Seminars headed by Milton Friedman. I was very fortunate to be in the right place at the right time, because in ’73 they had just opened the CBOE for trading. And a professor from the business school was on the board of the CBOE. I was getting, in a shoebox every month, computer cards with data about end-of-day prices. That was the basis for my dissertation. On my advisory committee, I had Fischer Black and Myron Scholes. And I had the support of the CBOE data in understanding the processes. I met many market makers. I sat on the floor of the exchange to see how it was being done. So in my dissertation I could implement a lot of observations that I realized by watching the traders.

YP: How did you become interested in options?

DG: I came to Chicago in September 1970. Myron Scholes and Fischer Black joined the faculty. I was exposed to the option pricing theory before it was published.

Even before I started my dissertation, I was working with a faculty member on a paper on options, on the put-call parity. That was before options started to trade in April ’73 on the CBOE. I got data from a professor who collected data from the OTC [over-the-counter] market at that time.

YP: Was talking to traders a common way to do academic research at the time?

DG: No. Actually, I think I was the first one to introduce the concept of ex post and ex ante tests in my dissertation. Usually when you do research, you look at the data and you assume that you can use the data as you see it. So if you have end-of-day data, you assume that you could have placed orders at those prices. While watching traders, I understood that what they see is not what they can trade on, because the next trade may be different. So I introduced the concept of ex post test, which assumes that what you see is only an indication. You have to place the order as the next step. You give an order, and you don’t know if it will be executed at the price you just saw minutes or seconds before. When you use that methodology, you see that markets are much more efficient than people assumed. But you also get different ideas about different strategies. You see how traders think, how they operate, and what kind of information they use. I believe that you have to have hands-on insight into how the decision-makers actually make decisions. Not what you assume about how they make decisions, but to see them in operation. And understanding the constraints, also.

YP: What happened after you finished your Ph.D.?

DG: I went to [University of California at] Berkeley for a few months, and then I immediately joined the Hebrew University. I finished my dissertation in December ’74. In ’75, I went to the CBOE as an adviser for two months during the summer. My project was to create an index for options, which they named GOI—the Galai Option Index.

YP: Was that an early version of Sigma?

DG: Absolutely. I created a synthetic option that was always 30 days at-the-money. You do it by interpolation. That was published in ’78 or ’79 in the Journal of Finance.

YP: You continued pursuing the idea of a volatility index after that.

DG: In the ’70s we didn’t have index options. In the beginning of the ’80s we started trading options on indexes. It took quite a few years for the SEC [Securities and Exchange Commission] to approve it, because at that time there was no underlying instrument. It was difficult to convince the SEC that you could hedge it. ETFs [exchange-traded funds] were 10 years away.

Once we started trading options on indexes, the idea was to use the same concept of a synthetic option that is always 30 days at-the-money, so we don’t have effects of skew and time effect. It was created by interpolation. It’s a pure play. The only thing you are left with is standard deviation.

We had a working paper that we offered in ’86 to the American Stock Exchange to launch it as a product. We appeared in front of the new products committee headed by professor Burton Malkiel from Princeton. They were skeptical about not having an underlying instrument and how this was going to be hedged, despite the fact that we brought some market makers who were pretty excited about it. But they decided at that time not to go ahead.

In August ’87 we visited the CBOE to present the idea. They seemed to like it, but then came the crash in October ’87. They were not looking for new ideas or products, but to recuperate from the crash.

YP: CBOE went on to develop the VIX. Are you satisfied that your contribution was recognized?

DG: Not exactly. We were in touch with them, but we weren’t sure what was going on until we saw the announcement in the Wall Street Journal that they launched the VIX.

YP: Do you think investors have an understanding of volatility and the impact on their portfolios?

DG: No, absolutely not. Not many understand statistics. I don’t want to generalize, but many don’t have the know-how. People are aware of the uncertainty, but I don’t think they know all the tools they can use to understand it and to control it. All investments have risk. Also, the word “risk” is misleading. You should use more than one word. Because market risk is different from credit risk and from reputation risk. And the matrix is also different.

YP: How did you envision investors using a volatility index?

DG: First of all, it would be very good information to understand the market and where the market is heading. It’s another parameter that you need in order to understand investments. Second, you can create strategies. People bought and sold volatility by using spreads, straddles. So you have different positions where you can buy or sell risk. But they are not very efficient because you don’t buy pure risk. You buy something in addition. So the index gave you an opportunity to trade risk. If you take a risky position in your portfolio related to the S&P 500, you can hedge some of the risk. We suggested to the exchanges that they offer instruments so you could trade and use it for hedging.

YP: Does the VIX have any predictive power?

DG: It gives you an indication of the perception of risk in the marketplace. For example, you see that for the last month or more the level of the VIX is very high. I think it’s a warning sign. The market is not sure at all about the direction. If we see, even for a few days, markets going up, it doesn’t impress me. Because I see the risk behind it. At this stage, I give a high probability that markets will further go down. From a macroeconomic view, to understand the perception of risk in the marketplace—yes, it gives you very good information.

YP: Do you believe volatility can be traded like any other asset class?

DG: Yes and no. It’s no different from oil prices. It’s not that people are interested in oil as a commodity. It’s just speculation. In this respect it’s an asset class. Do I personally use it or advise my clients to invest in it? Rarely. But again, you can have interesting trading strategies. For example, I know that some mutual funds use volatility options in a hedged way. You look at the term structure of volatility—short-term options and long-term options on the VIX—usually it’s not a flat function. Very often the short-term will be lower than the long-term. So at such time, you sell the long option and you buy the short one. You trade on the volatility differential. But during the pandemic, we see that short-term options on volatility are much more expensive than long-term ones. The market expects volatility to go down sometime in the future. So if you want to bet on it, sell the short one and buy the long one.

YP: So you see value in these strategies.

DG: In principle, yes. But I don’t believe in free lunches. If you have any bet on the market, don’t take it in an unlimited way. We saw what happened to traders who were betting against the VIX in February ’18. The VIX was very low, and people said it must go up, but they didn’t realize it would go up in one day to such an extent. And people for a long time made money by selling options because the VIX was very low. So you have a big group of traders who collected the premium, but in one day it jumped [by 116%], and all those who were naked short lost a huge amount of money.

YP: In the ’80s you also proposed volatility indexes for bonds and currencies.

DG: I think for many corporations to hedge their foreign currency risk, it can be a very good tool. I advise some corporations in risk management. And the problem is in general that you allocate budget for plant insurance, equipment insurance, car insurance, life insurance. You budget for many types of insurances that are very costly and very inefficient. But financial insurance is not being budgeted. CFOs are asked very often to manage the risks, but they’re not being given any budget.

Foreign currency risks can be managed in a better way if you have not only puts and calls but also options on volatility, and also an understanding of the macroeconomic consequences of volatility changes.

Interest rates are less volatile, so it’s less important. Volatility of interest rates is so minute, especially over the last 10 years. In the ’70s, when interest rates moved up and down substantially, it was more important.

YP: Are institutions more sophisticated about managing risk today?

DG: Banks are much more sophisticated today than they were in the past. They’re highly regulated. But in many companies that are not regulated, I think the risk culture is still not very profound and the boards very often neglect risk management. I have the opportunity from time to time to lecture board members, and most of the time they have no clue. They are pretty ignorant about risk management. They don’t know to ask the questions.

As far as asset management, asset managers in most places are not highly regulated. Hedge funds are not regulated at all. They’re opaque. I think the risk management culture in most of them is pretty bad, and we see it in each crisis. Many of them collapse completely, or they incur huge losses. You need resources, you need budgets, you need understanding.

YP: What is the biggest source of uncertainty right now?

DG: The uncertainty now is about the economic consequences of closing economies for one to three months. When will global traffic be resumed? Even 80% of it. For me, a major indicator of the economic recovery is when the airlines will get back to 80% of where they were before the crisis. We have a huge uncertainty about the tourism industry and all the related industries. I’m less concerned about the oil collapse and more concerned about air travel. It will be very costly, and I’m not sure how many of them will survive.

Usually when we do projections into the future, we look at past history. But the problem is all data concerning 2018-2019 is completely irrelevant. You can’t do any extrapolation. The VIX is important because the VIX is ex ante, forward-looking. Most of the indices used are backward-looking. But backward-looking financial data is completely irrelevant.

YP: What interests you right now?

DG: I just completed a joint paper on fintechs that have emerged over the last 20 years or more. I’m trying to see how they help financial intermediation and also to what extent they are disruptive to the banking industry. Do they have a more symbiotic relationship? Or are they going to disrupt the banks?

Another piece of research I’ve been pursuing for a couple of years is applying the concept of options to corporate finance, in estimating costs of capital and capital structure. We call it the contingent claim approach—using options to analyze the liability/equity side of the balance sheet of corporations. It changes quite a lot of the way you look at a corporation and how you analyze it. And also how you estimate cost of capital. In my view, most estimations of cost of capital are completely wrong. Equity is like a call option on the corporation. If you ignore it, you misevaluate the cost of capital in a substantial way.

Peterseil is an editor on the cross-asset markets team at Bloomberg News in London.

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