Leverage Goes Down When Markets Go Down

Here’s one simple way to think about financial markets. There is stuff, and the stuff has prices, and the prices move around. There is some inherent volatility of the stuff. For the last year, for instance, the volatility of the S&P 500 stock index was mostly in the neighborhood of 10% to 14%. The volatility of the US dollar/Japanese yen exchange rate was maybe 6% to 10%. These numbers change over time. For most of 2022, the S&P’s volatility was above 20%.

And there are investors, and the investors have portfolios, and the investors target some volatility for their portfolios. Not all of them: An index fund manager doesn’t target any volatility; she just buys the index and takes whatever volatility it happens to have. But a lot of big sophisticated investors do have some volatility target in mind. Big investment banks report and manage the value at risk of their trading books, a volatility-based measure. Big multistrategy hedge funds often explicitly target some volatility, generally one that is lower than the volatility of the S&P; their pitch to investors is that they offer high returns with lower volatility than the stock market.